Why we’re right to worry about the Facebook IPO

By Felix Salmon
May 29, 2012

The bad news is that the Greek stock market is down 58% over the past year; the good news is that it’s up 7% today. So far, so uncontroversial: while it’s possible to quibble with the standard CNBC convention that rising stock prices are always good and that falling stock prices are always bad, in the case of Greece it’s much harder.

In the U.S., for instance, investors with a reasonably long time horizon should like it when they can buy shares in productive companies at low prices, and dislike it when they’re forced to pay through the nose for such things. In Greece, by contrast, the level of the stock market gives a very good indication of just how bad the outlook for the country really is.

Which brings me to Andrew Gelman’s blog post yesterday, taking issue with Jim Surowiecki’s latest column, on Facebook. Surowiecki says that “there’s reason to be concerned at the spread of the dual-class structure”, on the grounds that companies with dual-class share structures tend to underperform the market. Gelman replies:

Who’s supposed to be “concerned” here? As a New Yorker subscriber, am I supposed to be concerned that dual-class firms underperformed the market? I just don’t get it. Why should I care? If the shares underperform the market, people can buy a piece of Facebook for less. That’s fine too, no?

I’m with Surowiecki on this one. For one thing, the stock market is the means that capitalist economies use to approximate what old-fashioned socialists like to call common ownership of the means of production. Surowiecki’s point here is that when you’re dealing with companies which have dual-class share structures, ownership is divorced from control, and a small group of self-selected owner-managers seize control which rightfully belongs to the majority owners of the institution. And when that happens, society as a whole loses out, because the company doesn’t generate as much value as it would or could under a more conventional ownership structure.

As for the discount which the stock market will give to companies under a dual-class structure, that’s not “fine too”. Sometimes, such discounts are OK. For instance, when I wrote about B-corps, I said that there is no reason that shares in such companies shouldn’t perform like normal shares. If company X trades at a constant discount to company Y, and both grow at the same pace, then shares in X will return just as much as shares in Y. But Surowiecki’s point is that companies with dual-class structures don’t grow at the same pace as the companies in the rest of the market. Which in turn means that the discount will go up and not down — and that, in turn, means that buying shares in such a company is not fine, and that you’d be better off not doing so.

And yet, in a world where more and more of us simply invest in index funds rather than picking our own stocks, the vast majority of us have an increasing amount of exposure to Google and Facebook and other relatively new-vintage companies with dual-class share structures. Insofar as those companies underperform their single-class peers, they’re dragging down stock-market returns for all of us.

The reason to be concerned about the rise of companies with dual-class share structures, then, is not all that dissimilar to the reason to be concerned about the rise of big private companies more generally. The stock market is no longer the common ownership of the means of production: it’s a place where early-stage investors can exit to a group of muppets and high-frequency traders. Here’s what I wrote just over a year ago:

At risk, then, is the shareholder democracy that America forged, slowly, over the past 50 years. Civilians, rather than plutocrats, controlled corporate America, and that relationship improved standards of living and usually kept the worst of corporate abuses in check. With America Inc. owned by its citizens, the success of American business translated into large gains in the stock portfolios of anybody who put his savings in the market over most of the postwar period.

Today, however, stock markets, once the bedrock of American capitalism, are slowly becoming a noisy sideshow that churns out increasingly meager returns. The show still gets lots of attention, but the real business of the global economy is inexorably leaving the stock market — and the vast majority of us — behind.

And here’s Surowiecki:

Public companies aren’t going to disappear, but we are witnessing a significant shift in power from shareholders to entrepreneurs and managers, one that may make the stock market less central to American capitalism.

What we’re saying here is that there’s a significant shift going on, and that it’s worth examining and worrying about. Insofar as the stock market is a dog-eat-dog world governed by caveat emptor, maybe there’s nothing to worry about. One person’s loss is another person’s gain. But insofar as it’s bigger than that — insofar as it’s an engine of capitalism and of capital formation and of efficient capital allocation — there are reasons to be less than ecstatic about the Facebook IPO. Because Facebook is Exhibit A in any thesis proposing that all of those things are broken right now.

Comments
13 comments so far

How quaint – the markets haven’t been a matter of individual shareholders vs management/insiders for over a generation. It’s mutual funds, pension funds, index funds and Wise Guys at IBs on one side and management/entrepreneurs on the other. Not at all clear that there even are two sides any longer, at least in some cases.

Nobody has to invest in these dual-class companies, individually or through funds. A QQQ-ex-duals index could easily be created. Can you not see the possible merit in having Page and Brin call the plays at Google rather than Blankfein, Corzine, Madoff and Fuld-types?

Who cares about FB? They belong on Madison Avenue, not in The Valley.

Posted by MrRFox | Report as abusive

MrRFox says, “Who cares about FB?”, the archetypical interwebs comment section crit. But this time I think it’s a valid question.

Posted by ottorock | Report as abusive

“we are witnessing a significant shift in power from shareholders to entrepreneurs and managers”

That’s nonsense. There are so few publicly traded companies that are managed by entrepreneurs, that this whole discussion is meaningless. Not only are founders in publicly traded companies extremely rare, but they are usually replaced far before a company even goes public, as the VCs that typically control them usually demand non-entrepreneurs to run them. This usually coincides with the company’s goals shifting from making products that make customers happy to just making money.

Having founders run a company can be a good thing- they are focused on the product and customer satisfaction, so usually the company can grow. Facebook may be the exception, but there’s no guarantee that if Zuckerberg was forced to yield to Wall Street that he wouldn’t end up like Yahoo. I don’t expect them to succeed, with or without his control of the company, but if you don’t like it you can always short the stock. After all, that’s the preferred tool for reining in intransigent management, isn’t it? (I will stick with puts, though).

Posted by KenG_CA | Report as abusive

As the first commenter noted, nobody has to invest in dual-class companies. So as long as the dual-class structure is disclosed to potential investors before they have to decide whether or not to invest, I don’t see a problem.

Personally, I would never invest in a dual-class company in which shareholders do not have the ability to vote out management, simply because it often leads to poor performance.

Posted by mfw13 | Report as abusive

All these comments ignore the question that Salmon posed, whether a dual-class market imposes a new tax on the long-term investor. My (amateur) guess is ‘yes’, mainly through increased risk and decreased earnings, but we shall see, I guess.

Posted by MattF | Report as abusive

Let me see if I have this straight:

1) Dual-class companies traditionally underperform fully public ones.

2) Anyone who read the FB S-1 (or saw press coverage about it) knew that FB was presenting itself as a dual-class company; this is Ford, not GM.

3) (1) and (2) were both known going into the IPO.

4) The implication of (1) is that a better-structured rival can compete in FB’s space.

5) FB is not a monopoly.

6) (4) and (5) were also both known going into the IPO.

Conclusion: the IPO was priced with full knowledge of the structure. (Brad DeLong suggested FB’s valuation appears to be based on influencing about 60% of the market; that seems a high expectation to me, but it may be countered if you assume the marginal gains are higher than Dr. D. does.)

Corrollary: anyone who bought FB hoping to influence the company’s direction or policy is a sucker. But anyone who was doing it with the goal of the 21st-century equivalent of “clipping coupons” made something rather near a fair bet.

Why would that ever be bad for the market?

Posted by klhoughton | Report as abusive

Let’s take a quick, high-level look at insider trading at Facebook Inc over the past 12 months. A total of 358,869,715 shares of Facebook Inc stock was sold by insiders, totaling $13,486,587,182. Over the same time 12 month time period, no shares of Facebook Inc were purchased by company insiders. A fool and his money are soon parted.

Posted by smsirus | Report as abusive

Felix, I don’t get it… I thought that the whole purpose of investing in index funds was that you WANTED exposure to everything out there, bad or good?

Obviously it is possible to outperform the index if you can identify (and avoid) classes of stocks that tend to underperform. You don’t even need to worry about picking stocks that overperform — just throw darts at whatever remains after you’ve eliminated the bad apples.

But index investors either believe that structural underperformance is a myth, or they don’t care. You’ve espoused that view often enough, so why are you reversing yourself now?

Posted by TFF | Report as abusive

smsurus – There weren’t many Facebook insiders. Just a handful with stock.

And it isn’t that common for employees to actually buy shares in their own company except through ESOPs. Problems with such purchases from the employees of Winnebago to Enron are well documented. Employees get stock options and exercise them.

Any financial adviser to a Facebook employee would recommend selling large amounts of stock at virtually any price. The reason is simple – diversification.

Posted by BrPH | Report as abusive

Also – looking at articles on dual class companies, the non-voting shares do trade at a discount on average. But that doesn’t mean that they are less profitable.

Posted by BrPH | Report as abusive

There’s a very simple response here. Investor’s are wise to avoid these dual class issuing companies. It signifies that management is not apt to be responsive to share-holder concerns, and the meme that share-holders can simply sell, is not sufficient and does not work at all for investors with significant holdings and those investors may be in sync with the little guy since they are buy and hold.

Posted by Sechel | Report as abusive

Felix, if FB shares shot through the roof post-IPO, you would have screamed “bubble!”. FB share price is tanking, or, becoming more affordable for buyers.
IPO’s do serve multiple purposes like liquidity, raising a war chest and reducing cost of capital.
An undervalued or overvalued stock is purely subjective.

Posted by capitalistic | Report as abusive

“Surowiecki’s point here is that when you’re dealing with companies which have dual-class share structures, ownership is divorced from control, and a small group of self-selected owner-managers seize control which rightfully belongs to the majority owners of the institution.”

Bit funny to be making this point in the context of Facebook though? The people who bought in the IPO aren’t anywhere near majority owners of the company, and they haven’t contributed anywhere near a majority of the invested capital. They’re along for the ride, and they’ve provided an exit opportunity for a small proportion of the early VC. Why would that make them better stewards of Facebook than its founder?

Also the “50 years of shareholder democracy” thing is a bit tonto to be honest. The golden age was the 30s and 50s. The era of shareholder democracy starting with the LBO boom was also the beginning of the big stagnation, with a small interruption for dot com, which was dominated by founder-driven companies.

TFF’s point is also a good one; at some point you need to make a decision whether you want the stock market to be an engine of capital allocation, or whether you want everyone to invest in index funds.

Posted by dsquared | Report as abusive
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