What went wrong with the Facebook IPO?
Mitchell Osak, Special to Financial Post
What was supposed to be one of the most heralded IPOs ever is turning out to be a disaster for Facebook and the banks that backed it. So far, the IPO has been a dud with the stock trading at $US 28.19 as of May 30, down 26% versus the $38 issue price.
What went wrong is indicative of the challenges valuing and executing IPOs in the technology space. Four main problems stand out:
Facebook and its lead investment bank Morgan Stanley committed a major faux pas aggressively valuing the company at $104 billion. Originally, Facebook set its share price conservatively at between $28-35 a share. Strangely, right before the IPO, the company upped the price to $38 per share or what the brokers considered “priced for perfection.” After the negative disclosures and insider selling, it became evident that the shares were not perfectly priced and fell to more realistic levels.
According to Ken Marlin, Managing Partner of Marlin & Associates, a leading technology-focused investment bank, “Pricing high-growth tech stocks is an art – mixed with some science. [The underwriters] got the “price” right, but got the ‘value’ wrong. For perspective, Facebook’s valuation was close to 100 times last year’s profits, significantly higher than tech giants Apple and Google that make far more money.
Realistically, no one really knows how to value millions of users, let alone Facebook’s 901 million users. Although user data – status updates, photos, likes and videos – has value, marketers have yet to figure out how to monetize it beyond simple display ads. The fact is “Facebook has not yet been able to find an ad model to generate revenues commensurate with its valuation,” says Saikat Chaudhuri, a management professor at Wharton.
Just prior to the IPO, Morgan Stanley and other analysts lowered Facebook’s earnings expectations. Facebook had repeatedly warned in its IPO filing about the challenges it was facing in mobile advertising: As consumers increasingly use mobile applications to access sites like Facebook, the firm will need to figure out how to shift its ad sales to mobile platforms, a place the company admitted it does “not currently directly generate any meaningful revenue.” It also cited growing competition from Google and social networking upstarts such as Pinterest, noting that its users could simply jump to another site if unsatisfied. This news likely contributed to the shares tumbling.
Of course, timing is everything and hindsight is always 20/20. However, if Facebook had executed its IPO last year behind tailwinds of rapid growth and significant buzz and only a distant mobile hiccup, they may have been able to support a higher valuation – at least until this quarter.
Poor execution of the IPO played a part in the share decline. As an example, Facebook increased the number of shares by 25% just prior to the IPO, an unwise strategy when the shares are actually over-valued. Those investors who received more shares than they wanted effectively became forced sellers when the quick profits failed to materialize a couple of days after the IPO.
Secondly, the timing of key activities makes you wonder what signals the company was sending out. In the banks handling the IPO, analysts – legally obliged to act independently – cut their forecasts for the firm after the IPO filing update. At the same time their investment banking colleagues and Facebook leaders were pushing for a sale at the very top end of their price range.
Confidence in the IPO fled after it became public that many of Facebook’s early backers were increasing the size of their selloffs. For example, Peter Thiel, one of Silicon Valley’s smartest investors and a Facebook board member announced he would be selling 16.8 million shares, up from 7.7 million shares. Though he likely knew nothing more than what was in the public filing, this decision could not have helped the sentiments around the IPO.
Thiel was not alone. Some 57% of the shares sold came from Facebook insiders. Typically the percentage of insider sales is under 10%. In other recent tech IPOs including Groupon, Zynga and Yelp the percentage was less than 1%.
More worryingly, investors could have been spooked by the actions of a major advertiser. Just prior to the IPO, General Motors decided to pull $10 million in advertising from the site, saying that the ads had proven to be ineffective. GM’s assessment is consistent with our firm’s social networking research which has found that Facebook users are less tolerant of being marketed to as compared to more business-focused sites like LinkedIn.
Can Facebook bounce back and justify its lofty $104 billion valuation? Maybe. It all comes down to whether it can quickly develop a mobile-enabled, profitable and defensible business model that does not alienate users. Moreover, there remains plenty of ways (e.g., as a payments platform, via media content sales, or through subscriber revenues) to profitably grow revenue.
In the short term, however, the company may have to continue splashing its site with advertising to generate more revenue. This raises the specter of Facebook becoming another MySpace, a failing social network site littered with ads. If this happens, users may then defect to another, less cluttered social network, triggering further share prices declines.
Mitchell Osak is Managing Director of Quanta Consulting Inc. Quanta has delivered a variety of winning strategy and organizational transformation consulting and educational solutions to global Fortune 1000 organizations.