Facebooks Failed IPO and the Era of Insider

Capitalism

By Stephen F. Diamond
Santa Clara University School of Law
September 2, 2012
An earlier version of this paper appeared in Dissent online.

Stephen F. Diamond. Contact: sdiamond@scu.edu

Electronic copy available at: http://ssrn.com/abstract=2140507

Abstract
The initial public offering (IPO) of Facebook is the most important failed IPO in the
history of the American capital markets. Explanations for the failure largely focus on the
widely publicized problems at Nasdaq, the exchange venue where the offering took
place, and the role of the investment banks that helped lead the IPO. This paper argues
that the problems were likely caused by a confluence of two other important factors: the
pressures of what I define as fictitious capital and the internal culture of the company
itself created by Mark Zuckerberg, the founder and dominant shareholder of the
company, aided and abetted by early investors such as the libertarian Peter Thiel.
These factors suggest the emergence of a new period in capitalism that I call insider
capitalism where key investors ally with founding entrepreneurs to exploit informational
advantages to appropriate value. The paper thus suggests that there is a deeper
structural and ideological problem extant in modern capitalism.

Facebooks much-maligned initial public offering has led to a wealth of

commentary, a lot of it focused on the wrong issues. There is certainly enough blame to
go around, but assigning blame requires clarity about what exactly happened. It will
likely take several congressional hearings, a couple of regulatory agency investigations,
and some shareholder lawsuits to flesh out all of the facts.
But while we wait let me suggest an argument, one that fits together many of
those facts that are available and goes a long way, I think, to satisfying the demands of
Occams razor. In short, the Facebook IPO may turn out to be the largest pump-anddump securities fraud ever perpetrated against U.S. investors. This argument not only
helps explain how this debacle unfolded but suggests that we need to rethink the way
that our economy, particularly in high technology, is shaped.

A Social Network Looking for an Exit

To recall the basic scenario: Mark Zuckerberg and some Harvard classmates
founded Facebook in 2004. The 2010 film Social Network captured the atmosphere of
phenomenal, rapid growth surrounding Facebook, as well as the internal tensions
among some very young and inexperienced entrepreneurs. The young company now
has some 900 million users on its platform worldwide. Not only is the company making a
large amount of money (an impressive $1 billion in net income on revenue of $3.7 billion
in 2011, for a profit rate of 27 percent), but it can arguably claim to have had a
significant impact on the wider social and political world. Most notably, the social
network played an important role in allowing young Egyptians to communicate during
their uprising against the dictatorial Mubarak regime.
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However, Facebook was not built just to be a social phenomenon, although

Zuckerberg, who is its CEO and remains its dominant shareholder, tries at times to
suggest that. Facebook was built with millions of dollars of investment capital provided
by major venture capital firms and investment banks. At the beginning of 2011 Goldman
Sachs raised $1.5 billion from investors in an offshore private placement for the
company and invested an additional $450 million of its own funds. Many of Facebooks
engineers and computer scientists were willing to work for the company in return for
stock options. That, too, is a form of capitalist investment. The founders, the employees,
the venture capitalists, the investment banks, and the investors were all looking for an
exit opportunity to turn their investments of cash and human capital into a profitable
return. That required a public offering and a listing on a major stock exchange.
Facebook, of course, lives in a capitalist environment that imposes constant
pressure to innovate and grow, lest it fall by the wayside as have so many technology
companies. In fact, Facebook has succeeded so far by competing aggressively against
companies like MySpace. To continue that success Facebook needed a liquid market
for its stock to use as an acquisition currency. This was demonstrated by its acquisition
of the hot startup Instagram in April for a billion dollars. Instagram is not profitable and
has only a handful of employees, but it was catching on among Facebook users as an
alternative social platform. To nip it in the bud, Zuckerberg offered the company a
combination of cash and (presumably) valuable Facebook stock.
To sum it up: there was intense pressure on Facebook to conduct this IPO.
Over time, thousands of Facebook shares had, in fact, already been sold and
traded among a small number of wealthy investors and institutions on new private
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secondary markets like SharesPost and SecondMarket. On these relatively limited and
inefficient markets Facebook shares were valued as high as $44 a share, sending the
overall valuation of the company over the $100 billion mark. Facebook appeared to be
on track for one of the most successful IPOs in U.S. history.
The company selected a team of investment bankers from Morgan Stanley with
many decades of experience on such deals, including the largest IPO in U.S. history (of
the Visa corporation). The legal teams for both the underwriters and the company
included lawyers who have been doing technology offerings successfully in Silicon
Valley for many decades.
And yet it all went horribly wrong.

The NASDAQ Glitch

On the day of the IPO, May 18, there was an unexplained delay in the opening of
trading in Facebook stock. The precise details are not yet known, but the result was that
confidence in the stock dissolved quickly, causing many traders to cancel their orders.
That apparently caused problems with NASDAQs electronic trading system, and the
exchange struggled to print or set the opening price of the stock. The underwriters had
priced the deal at $38 per share, which is the amount they pay the company for the
shares, minus their trading commission. But the opening price is set by supply and
demand as measured in the computer matching system controlled by NASDAQ. When
it finally opened, the exchange announced an opening price of $42 per share.
That price should have represented a stable equilibrium, or market clearing,
price that, at least for a brief period, matched all willing sellers and buyers. But the
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exchange was instead hit with an unprecedented wave of orders, processing 82 million
trades in the first thirty seconds of actual trading. It appears that so-called high
frequency traders, or HFTs, were able to use the unusual trading process to make
small per share gains that added up to larger profits for them. HFTs are a relatively new
phenomenon in the capital markets, but computerized trading now accounts for as
much as 60% of the daily trading in the financial markets. The cancellation of many
trades combined with the news that retail (individual) investors were receiving an
unusually large number of shares further eroded confidence in the stock. The price
began to sink quickly.
The underwriting banks were then forced to step in and offer to buy the stock
they had just sold to investors in order to prevent a collapse. This is, in fact, not a
manipulation of the market but part of the means by which a market clearing price is
ordinarily established for the stock under federal securities law. In theory it should
prevent speculators from taking advantage of less experienced investors.
However, the banks were trying to catch a falling knife. The wave of selling that
was triggered in the first few hours nearly overwhelmed the effort of Morgan Stanley
and the other underwriters. Facebook closed that Friday back at $38 per share, the
same price that the underwriters had paid to the company, erasing the gains they had
expected to make. In fact, the banks were well out of the money because of the
reported billions they had to expend to prop up the price. A week later, once the banks
stopped supporting the price and short sellers were able to enter the market, the stock
was trading at close to $31 a share, more than 25 percent below the opening price.

There were, it must be admitted, some important advance warning signs, and
some argue that if investors missed these signs and lost money it was their own fault. It
is easy, of course, to connect the dots in hindsight. But it is very unlikely that any of
these commentators themselves understood the nature of the problems in advance.
And consider what is happening now to many retail investors. To insure that an IPO, a
highly complex and risky process, is successful, shares are generally allocated largely
to institutional investors like pension funds, mutual funds, insurance companies, and
hedge funds. These entities are much better able to manage the risk-reward calculus in
a new listing than are individuals. Ordinarily, retail investors will be allocated between
10 and 15 percent of the shares offered. Because of the limited shares available, retail
investors typically order more shares from their broker than they want, or can even
afford, on the assumption that they will only receive, perhaps, 10 percent of their
request.
Yet, in the Facebook IPO, retail investors were allocated approximately 25
percent of the shares offered, which meant that many of them received 100 percent of
their original request. Since an investors order is an offer to buy, once they receive a
written confirmation of the order they have entered into a firm contract with their broker,
who, in turn, is selling shares he has ordered from the underwriter. That small investor,
therefore, is now on the hook for that order at the IPO price of $38 per share.
Bloomberg News estimates that retail investors have lost more than $600 million in the
IPO so far.

Occupy Silicon Valley?

Some in Silicon Valley are attempting to tap into the anti-bank sentiment stoked
by Occupy Wall Street to suggest that the IPO was a victory for entrepreneurs. The
basis of this argument is that by pricing the IPO at the higher end of its expected trading
range, more money ended up in the hands of the company and less in the hands of IPO
speculators. Purveyors of this argument recall the dot-com boom in the late 1990s when
many technology companies went public at, for example, $30 a share only to see the
stock price shoot up in the first few days due to a near hysterical hunger for shares.
In retrospect, the dot-com period should be seen as an early stage of a massive
bubble of fictitious capital building up in the American economy of. Despite warnings of
what then Federal Reserve Bank chairman Alan Greenspan, following Yale economist
Robert Shiller, called irrational exuberance, money flowed into the American economy
from around the globe. Low interest rates put in place by the Federal Reserve enabled
consumers to borrow and spend and investors to borrow and invest. Too much money
flooded into too few good investment projects. The dot-com bubble burst only to see
capital migrate to the housing market and its associated derivative instruments, such as
credit default swaps and synthetic CDOs, which, in turn, magnified that market and the
wider impact of its subsequent collapse, dramatically.
Now, as we struggle to recover from the disintegration of the housing market, a
new bubble has appeared in the social networking and broader high-tech sector. Hopes
have been stoked that social networking can trigger a broader shift in investing and job
creation. Its apparent success even led President Obama, who raises significant
campaign funds from Silicon Valley, to sign the JOBS (Jumpstart Our Business

Startups) Acta law drafted and lobbied for by venture capital and the tech sector
which dramatically weakens protective features of federal securities law that have been
in place for many decades. The Facebook IPO was seen as a potential savior for the
cash-starved California state government, which hopes to cash in on taxes collected
from newly minted Facebook millionaires and billionaires. A wave of follow-on IPOs by
other Valley social networking companies was widely expected to follow a successful
Facebook IPO.
Valley entrepreneurs were said to be smarter about the wily practices of Wall
Street than they were in the dot-com days. Thus, Facebook should actually be
congratulated for pricing their IPO high enough that there was no early pop in the
stock price, and most of the money raised went to the company instead of to Wall
Street speculators. In theory, that means more money can be used to create jobs, build
these new businesses, and apply their allegedly magical technical features to creating
new efficiencies for the entire economy.
The only problem with this argument is that this is not what happened.

Insider Capitalism
Insiders including Mark Zuckerberg and other founders, venture capitalists like
libertarian Peter Thiel, and later investors like Goldman Sachs and the Russian
investment firm DST actually sold far more shares than the company itself. Of the 421
million shares sold in the offering, existing insiders sold 241 million while the company
sold only 180 million. Zuckerberg sold 30 million shares, Thielon behalf of his venture
capital firmsold 16.8 million shares, DST sold 45.6 million shares, and Goldman
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Sachs sold 24.3 million shares. That means that of the $16 billion raised in the IPO, $9
billion went to insiders while $6.7 billion went to Facebook itself, and the underwriters
collected $176 million in fees and commissions. That lopsided sales structure is highly
unusual and was one of the warning signs that some analysts expressed concern about
in advance of the offering. It is not considered prudent for insiders to be seen selling
their shares in an IPO while the company is asking new investors to put their money into
it. Typically, employees and early investors sign lock-up agreements that dont allow
them to cash out of the company for six months.
But at Facebook key insiders were allowed to sell immediately, while others were
granted rights to sell in follow-on offerings at the end of three months. In addition, the
amount that those insiders could sell immediately increased significantly very late in the
offering process. This step took many analysts by surprise. But this step is, in many
ways, the key to unraveling what caused the IPO process to go so badly.

An Alternative Scenario
In the months leading up to an IPO, a complex negotiation takes place between
the investment banks and the issuer, each advised by their own securities lawyers,
about the volume and price of the shares to be sold and the content of the disclosure
about the business to be provided to investors. While this is often a contentious process,
it seems that at Facebook it was particularly stormy.
Two key facts suggest that there were significant disputes. First, on May 9, only a
week or so in advance of the scheduled IPO date, Facebook amended its prospectus,
adding statements about its concern that the number of daily Facebook users was
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increasing more rapidly than the rate of advertising delivered to their users, largely
because of increased use of mobile phones and tablet computers like the iPad. Since
Facebook generates the bulk of its impressive revenue from ads, anything that would
negatively impact that revenue was critical to investors assessment of the value of the
business.
This late admission, three days after the road show promoting the offering to
those investors had begun, was very unusual. Even odder, the admission was
accompanied by a one-page statement, filed with the SEC and made available to
investors on its EDGAR database, highlighting the three specific places in the 200
single-spaced pages of the prospectus where the company altered its earlier disclosure.
While some argue this meant investors were adequately warned of the risks
associated with the offering, this is hardly the case. The original purpose of the New
Dealera federal securities laws that regulate public offerings was to slow down the
process in order to prevent investors from being swayed by hype into making an
imprudent decision. But with the offering date only a few days away, even sophisticated
analysts who received phone calls from Facebook to tell them about the disclosure had
little time to assess its impact. At this point the prudent step would have been to delay
the IPO in order to allow investors to revise their estimates of the value of the business.
That may, in fact, have been the recommendation of some on the banking and legal
teams who were advising Facebook. If the company refused this advice then it would
have made sense for the SEC to impose what is known in securities law as a cooling
off period until the markets could absorb the important new information.

A second key fact helps shed light on the process. On May 17, Facebooks
pricing committee, made up of several members of its board of directors together with
the companys CFO David Ebersman, met on a conference call with Morgan Stanley
representatives to decide on the price that the underwriters would pay for the shares of
the company. Ordinarily such a pricing call is a relatively short and even pro forma
event. While the question of price is obviously critical to the success of the transaction,
by the time this meeting takes place the price is reasonably well established within the
team structuring the offering. While it was initially reported that this meeting went as
expected, Bloomberg News later disclosed that the CEO of Morgan Stanley, James
Gorman, was also present on this call.
The presence of the CEO of the lead investment bank on a pricing call is, to put it
mildly, highly unusual. It would not be surprising to learn that Gorman has never before
participated in a pricing call while CEO. The most plausible reason for his joining the call
is that the bankers handling the transaction needed him to help push back against the
CFO and the Facebook board because of a disagreement over the price of the IPO.
While one might think that the bank would always favor the higher commission
that comes with a higher price, this is not, in fact, true. Experienced bankers know the
legal risks of overpricing an IPO. The relevant provision of the federal securities laws
measures the damages owed to defrauded investors based on the IPO price. The
higher that price, the greater the potential damages owed by the company, its directors
and officers, the underwriters, and the auditors. Not all so-called underpricing of IPOs
is irrational. The far more radical underpricing of IPOs seen in the dot-com era was the
exception that proves the rule.

There are now reports that the large institutional investors who received phone
calls from bankers in the wake of the May 9 disclosures were only willing to pay $32 per
share while retail investors remained willing to pay at least $40 per share. It seems
likely, therefore, that following those disclosures about the trouble the company was
experiencing in the mobile segment of its business, the underwriting bankers wanted to
lower the price and had included Gorman on the call to add weight to their position.
While some, particularly dot-com era Wall Street analyst Henry Blodget, are quick to
suggest that Morgan Stanley gave their institutional clients an advantage over retail
investors by calling them to discuss the May 9 amendment, it is actually more likely they
were using the feedback from those clients to push back against the efforts of
Zuckerberg and the Facebook board to push the size and value of the IPO to recordsetting levels.
The May 9 disclosures could not have come out of the blue. The negative impact
that increasing mobile use by consumers was having on advertising revenues was a
widely known problem for many social networking companies. Given that earlier
versions of the prospectus, including one filed as late as May 3, had several comments
on the issue, the IPO deal team preparing the prospectus had clearly discussed it.
However, those earlier comments only referred to the possible future impact of
increased mobile use on Facebook revenues and thus profits. So what happened
between May 3 and May 9 that caused the company to alter that disclosure with a clear
statement that increased mobile use was causing a problem now for the company?
There are only three possibilities:

1) The company was unaware of a serious problem at the heart of its own business
until after May 3. Once they discovered the problem they shared it with potential
investors in the May 9 amendment.

2) The company was aware of the problem but hid it from the underwriters and only
disclosed it when the underwriters discovered the problem through independent
investigation.

3) Both the underwriters and the company were aware of the problem but there was
a disagreement about whether and how to disclose it to investors. When the
underwriters received negative feedback from investors about the price of the
IPO they were able to use that to persuade the company to revise the disclosure
and, on May 17, reduce the price of the IPO below $40 per share.

I believe the third scenario to be the most likely. It strains credulity to suggest that
a company made up of computer scientists and engineers and led by someone hailed
as a business genius learned out of the blue some time between May 3 and May 9 that
there was a serious problem because of the growing number of mobile users of their
service. There are likely reams of data supporting that conclusion inside the company. It
is also unlikely that the underwriters, who always engage in months of due diligence
prior to taking a company public, were not aware of at least some aspects of that
problem. It is not at all unusual, however, to have a disagreement over the way in which
such a business problem is described in a prospectus.

There is a big difference between a current and a potential problem. There is no

investment banker or securities lawyer who would not have strongly recommended to
his or her corporate client that this kind of information be disclosed as quickly as
possible to investors, and that the company allow investors time to digest the impact of
that information on their valuation analysis. In the case of Facebook, that fundamental,
principled, and legally required approach was apparently ignored.
The only explanation is that the company, which is controlled by a young and, by
many accounts, rather hubristic CEOwho, unlike the lawyers and bankers advising
him, has never participated in an IPO beforepushed back against their
recommendations. It appears that Zuckerberg pushed back so hard that it took until May
9, more than three months after the first version of the prospectus was filed with the
SEC, to disclose critical information to the SEC, NASDAQ, and, most importantly,
potential investors.
The decisions to increase 1) the price well above the $32 per share sophisticated
investors said was the right price, 2) the percentage of shares that insiders sold in the
offering, and 3) the percentage of such shares offered to unsophisticated retail investors
suggest that this IPO was a giant pump-and-dump operation. The transaction was not
intended to link entrepreneurial talent with the savings of thousands of ordinary
Americans but instead aimed at stoking the ego of a company led by arrogant and
inexperienced twenty-somethings.

Other Peoples Money

The critical early-stage investor in Facebook was current board member Peter
Thiel, a noted fan of Margaret Thatcher and Ayn Rand. Ironically, this recipient of two
degrees from Stanford argues that a college education is overrated. Thiel funds a
program that encourages young people to emulate Zuckerberg and drop out of college
to start companies like Facebook. He is also a supporter of Singularity University, a new
private education program-cum-technology think tank. Both Thiels business offices and
Singularity are located, again ironically, on federal government property: NASAs
Research Park on Moffett Field in Mountain View and the Presidio in San Francisco.
Thiel, according to a recent profile in The New Yorker, thinks the social unrest
visible in movements like Occupy and strikes in Greece contains the potential for a
worldwide conflagration. He is critical of both welfare provisions and the extension of the
suffrage to women. He has openly longed for the 1920s (which was certainly before the
emergence of the modern welfare state and securities laws, but followed the passage of
the Nineteenth Amendment). In the manner of Rands hero John Galt, Thiel sees
investment in young technology entrepreneurs like Zuckerberg or Sean Parker as a way
to rescue humanity from what he believes are the totalitarian instincts of social
democracy. In a 2009 manifesto he posted on the Cato Institute website, he wrote,
The fate of our world may depend on the effort of a single person who builds or
propagates the machinery of freedom that makes the world safe for capitalism.
Apparently, his vision of capitalism includes the possibility of a single individual
controlling more than 50 percent of the shares of a $100 billion global corporation that
openly aspires to exploit the personal information of its nearly 1 billion users.

Instead of fantasizing that the global economic crisis can be solved by college
dropouts or by the weakening of federal securities law, however, aspiring young
capitalists should be reminded that when one is using what Justice Brandeis called
other peoples money, certain principles of social responsibility must be respected.
Perhaps these media darlings should be reminded as well of the myth of Icarus,
who thought he could fly to the sun on the wings prepared by his father, Daedalus. The
wings, though, were made of wax and melted as Icarus approached his destination. He
fell to his death in the sea far below. The silence of Mark Zuckerberg in the wake of the
Facebook disaster suggests that like Icarus, he, too, is feeling some heat.