Over the past year the “Occupy” movement has highlighted the issue of income inequality and criticized the institutions that are perceived to perpetuate it. Wall Street was a natural first target as the “rules of the game” seem to disproportionately benefit the powerful few.
Nowhere does this appear truer than in the market for initial public offerings (IPOs), where banks help companies to raise capital and become publicly traded. In the traditional IPO process companies ask banks to help them to navigate the regulatory review process required in all markets and ultimately price and distribute their shares to public market investors. After submitting the necessary regulatory filing documents (The S-1 in the U.S.) and while they are being reviewed, banks attempt to determine an appropriate price for the shares.
To do this they approach their clients (institutions and individuals) and solicit indications of interest (shares investors would want at various prices). Through these interactions the bank builds its ‘book’ of investor demand (the process is thus referred to as book building). Once regulators approve the offering for formal sale, banks set the final price and allocate shares to clients in their book. The rules give banks discretion in their allocations with favoured institutional clients typically getting the vast majority of shares. So banks receive their large fees and a favoured few receive shares (which typically quickly rise 10-20 per cent in early trading). Not “fair” to the many small investors who get shut out.
With this backdrop, the potential Facebook IPO generated a lot of buzz in late 2011. Many Wall Street critics were hopeful Facebook would do something bold to shake things up. In 2004, Google (the company whose goal was to “not be evil”) attempted to do just that when it used an auction to sell its IPO shares. In an auction, investors place bids for shares at various prices and allocations are mechanical (going to those who bid enough) rather than discretionary. Many have argued that such a system should both lead to better pricing and be fairer to investors.
Following Google’s lead seemed possible since Facebook's COO, Sheryl Sandberg, was with Google at the time of its IPO. Other commentators have hoped Facebook would be even bolder and issue shares using a direct public offering, or DPO. In a DPO Facebook would sell shares to investors directly without using any Wall Street bank support. Selling directly to shareholders seemed plausible for a firm with over 800 million active visitors to its web site. By selling directly, Facebook could both build even more goodwill with its users and save hundreds of millions in banker fees.
So what did Facebook choose to do? Rather than thumbing its nose at Wall Street, it chose to embrace it, opting for the traditional book building process for the sale of its IPO shares. In an era where so many are sceptical of Wall Street’s virtues, it is more than a little surprising that a firm “not created to be a company ... [but]built to accomplish a social mission – to make the world more open and connected” (as quoted from Mark Zuckerberg’s letter to shareholders that accompanied Facebook’s S-1) would chose such an arcane and closed system to raise capital.
To better understand this choice, it is worth stepping back and asking why Facebook chose to go public at all. Like many technology companies, Facebook relies heavily on stock-based compensation (option and restricted stock) in lieu of cash (Facebook’s S-1 indicates that its policy is to have cash compensation below market level). A large number of Facebook employees would be financially better off with a higher IPO price.
In his letter to shareholders, Zuckerberg says Facebook is “going public for our employees and investors ... to make [their shares]worth a lot”. Many early investors also hoped to also be able to liquidate some of their positions in Facebook to capture some gains in an otherwise difficult market. When Facebook first disclosed details of their offering they noted that existing owners hoped to sell up to 200 million shares in the IPO (about 9 per cent of their pre-IPO ownership). In most cases, these large sales by insiders scare markets who question why insiders are selling if this is such a great investment (particularly given the absolute dollar value of these sales). The bankers would be needed to tell the story and quell concerns.
So how have things worked for Facebook? Simply put, the offering has been an incredible success. To see this it might be best to compare it to Google. When Google attempted to go public, initial owners hoped to sell about 4 per cent of their shares at a price between $108 and $135 per share. In spite of strong demand, Google had to cut the price to $85 and initial owners cut their sales in half. In contrast, Facebook increased both its price (from an initial range of $28 to $35 to an IPO price of $38) and initial investors increased their sales (up to as much as 300 million shares).
Traditional book building has given Facebook the best shot of selling the maximum number of shares at the highest price and its choice to stick with tradition is, in my opinion, a strong vote of confidence for Wall Street. While the traditional IPO process is not perfect, it survives because it gives companies the best shot at raising the capital it needs to grow at the best price possible. Not fair, but probably the best thing for these companies and ultimately for all of us.
Craig Dunbar is Associate Professor of Finance, Ivey School of Business, Western University