Felix Salmon

Where banks really make money on IPOs

Felix Salmon
Mar 11, 2013 06:22 UTC

Every time an IPO has a big pop on its opening day, the same tired debate gets reprised: did the investment banks leading the deal rip off the company raising equity capital? The arguments on both sides are well rehearsed — I covered them myself in no little detail, for instance, after LinkedIn went public, in 2011.

Back then, I had sympathy with the bankers:

If the large 7% fee does anything, it aligns the banks’ interests with the issuer’s. If the banks felt they could make millions more dollars for themselves just by raising the offering price, it’s reasonable to assume that they would have done so. I’m sure that the institutions which were granted IPO access are grateful to the banks for the money they made, but that gratitude isn’t worth a ten-figure sum to the ECM divisions of the banks in question.

Today, however, I have to take all of that back. And it’s all thanks to Joe Nocera, who has a great column this weekend, where he uncovers a bunch of documents in one of those interminable securities lawsuits against Goldman Sachs. The documents should have been sealed; they weren’t. And now, thanks to Nocera, we can all see exactly where Goldman makes its money, when it comes to IPOs. (It’s fantastic that he put those documents online, although it’s hard to read them in the browser; here’s the download link which the NYT weirdly removed from its own site.)

The lawsuit in question concerns the IPO of eToys, back in 1999. The company sold 8.2 million shares, raising $164 million; Goldman’s 7% fee on that amount comes to $11.5 million. If Goldman had sold the shares at $37 rather than $20, it would have received an extra $10 million — and what bank would willingly leave $10 million on the table?

What Nocera has discovered, however, is that Goldman was not leaving $10 million on the table. Instead, it was making more than that — much more — in kickbacks from the clients to whom it allocated hot eToys stock.

Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the numbers in something it called a trade-up report, the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O.’s and demand that they reward Goldman with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50 percent of the first-day profits be returned to Goldman via commissions, according to depositions given in the case.

eToys opened at $78 per share, which meant that Goldman’s clients were sitting on a profit of $475 million the minute that the stock started trading on the open market. In most cases, the clients cashed out — which was smart, because eToys didn’t stay at those levels for long. But if Goldman got back 40% of those profits in trading commissions, then it made $190 million in commissions, compared to that $11.5 million in fees.

If Goldman had raised the IPO price to $37 per share, then yes its fee income would have gone up by $10 million, to $21.5 million. But — assuming the stock would still have opened at $78 — its clients’ opening-tick profits would have come down to $336 million, and Goldman’s 40% share of that would also have come down, to $135 million. Total income to Goldman? $156.5 million, rather than $201.5 million. If the IPO price were higher, Goldman’s total take would have gone down by about $45 million.

All of these numbers are hypothetical, of course, but the bigger point is simple: if Goldman manages to get kickbacks, in terms of extra commissions, of more than 7% of its clients’ profits, then it has a financial incentive to underprice the IPO. And Goldman’s clients were desperate to give it kickbacks: they didn’t just route their standard trading through Goldman, since that wouldn’t generate enough commissions. Instead, they bought and sold stocks on the same day, at the same price. Capstar Holding, for instance, bought 57,000 shares in Seagram Ltd at $50.13 per share on June 21, 1999 — and then sold them, on the same day, at the same price. Capstar made nothing on the trade, but Goldman made a commission of $5,700. Capstar’s Christopher Rule says that in May 1999, fully 70% of all of his trading activity “was done solely for the purpose of generating commissions”, so that he could continue to keep on getting IPO allocations.

Goldman, of course, revealed none of this to eToys. Instead, they pitched eToys with a presentation saying, on its first page, in big underlined type, “eToys’ Interests Will Always Come First“. On the page headlined “IPO Pricing Dynamics”, they explained that the IPO should be price at a “10-15% discount to the expected fully distributed trading level” — which means not to the opening price, necessarily, but rather to the “trading value 1-3 months after the offering”. After all, this was the dot-com boom: everybody knew that IPOs were games to be played for fun and profit, and that the first-day price was a very bad price-discovery mechanism.

If you look at the chart of what happened to the eToys share price in the first few months after the IPO, the price fluctuated around $40 a share — which means that by Goldman’s own standards, it really ought to have priced the IPO much closer to $37 than to $20. And this was no idiosyncratic mistake on Goldman’s part: Goldman’s other IPOs all fit the same pattern. For instance, look at the three deals run by Lawton Fitt, the Goldman executive in charge of the deal, before the eToys IPO. First was pcOrder, which went public at $21 and opened at $55.25. Then there was iVillage: that went public at $24, and opened at $95.88. Finally, there was Portal Software, which went public at 414 and opened at $36. When eToys went public at $20, Fitt knew exactly what was going to happen: indeed, she bet her colleagues that eToys stock would hit $80 on the opening day. She knew her market: it actually traded as high as $85.

Some big names jump out from the documents here — none more so than Bob Steel, who was then Goldman’s co-head of equity sales, and who went on to put out financial-crisis fires for Hank Paulson at Treasury before going on to become the CEO of Wachovia. Steel wrote a detailed email to Tim Ferguson, the chief investment strategist at Putnam Investments, saying that he would try to help Putnam out “with regard to IPO allocations”. At the same time, however, he added that “we should be rewarded with additional secondary business for offering access to capital markets product”. Which, in English, means that if Putnam got access to Goldman’s IPOs, it would have to steer more soft-dollar commissions to Goldman.

Meanwhile, if you didn’t toe the investment banks’ line, they would cut you. Toby Lenk was the CEO of eToys, and in a 2006 deposition he was asked whether he ever “voiced any displeasure” with Goldman about the fact that they left so much money on the table. He said no — and added “a little story” about why it was never a good idea to annoy a big investment bank. In 2000, Lenk explained, when eToys was desperate for money, it raised some cash through a convertible debt offering:

We initially selected Merrill Lynch to be our lead convertible debt underwriter, and Goldman Sachs came in and put a strong foot forward to take that away, and Merrill Lynch we kept as a secondary underwriter in the secondary position and kept them in the deal. They were in the deal, and I believe it was the morning of the deal going into the marketplace, or the night before, or right around that time, Merrill Lynch’s lead internet analyst, Henry Blodget, downgraded our stock as that was going into the marketplace, and made it extremely difficult for that placement to happen.

The investment banks have punitive power over us. We need them to raise capital. You don’t go complaining to investment banks because they will crush you, and that is a perfect example. We got penalized by Merrill Lynch. We got slapped hard, and it nearly sank that offering, and I can tell you that nearly sank the company.

This is just the flipside of pumping up companies in order to get investment banking business: if you lose that business, then you do the opposite, and downgrade the company just when doing so causes the most pain. As a result, as Lenk says, you didn’t cross the bankers — and you certainly didn’t cross Goldman.

All of which puts Goldman’s 7% fee into very interesting perspective. Goldman likely made much much more money on the eToys IPO from its buy-side clients than it did from eToys itself. Indeed, it could have offered to run the IPO for free, the IPO would still have been very lucrative for Goldman. But of course eToys would never have given Goldman the IPO mandate if Goldman had offered to run it for free — because then it would have been obvious where Goldman’s loyalties resided.

The real purpose of the 7% fee, it seems, was to make eToys think that it had hired Goldman and that Goldman was working for eToys — and also to tie eToys into a close relationship with Goldman. (Lenk, for instance, became a personal client of Goldman Sachs shortly after the IPO.) As Andrew Clavell once put it:

If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

The 7% fee is a very large shiny object, which diverts everybody’s attention from where the real money is made — or at least did, back in 1999. Have things changed since then? Here’s Nocera:

The documents are old. Some will dismiss them as relics of another era. But I continue to believe that the mind-set created by the I.P.O. madness of the late 1990s never really went away. To this day, an I.P.O. with a big first-day jump is considered a success, even though the company is being short-shrifted. To this day, investors know that they are expected to find ways to reward the firms that allocate them hot I.P.O. shares. The only thing that is truly different today is that few on Wall Street are so foolish as to put such sentiments in an e-mail.

That’s the one point at which I’m willing to disagree with Nocera. Nothing ever changes much on Wall Street, including the degree of professional foolishness. I’m sure if a determined prosecutor went hunting for similar emails today, she could probably find them. But I don’t know what the point would be. Because there’s nothing illegal about asking buy-side clients to send commission revenue your way — or even about explaining to them how much money you’ve helped them make. eToys’ creditors might ultimately win this case against Goldman, or they might not, or the two sides might settle. But whatever happens, the implications for sell-side equity capital markets desks will be minuscule. Because the amount of money they’re making right now will always dwarf any potential litigation risk 15 years down the road.



interesting analysis. Could you elaborate a little on how you got to the 40% on trading commissions?


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Why going public sucks: it’s not governance issues

Felix Salmon
Jul 17, 2012 18:14 UTC

Marc Andreessen agrees with me that it sucks to be a public company. But he disagrees on the reasons why:

Basically, it was very easy to be a public company in the ’90s. Then the dot-com crash hits, then Enron and WorldCom hit. Then there’s this huge amount of retaliation against public companies in the form of Sarbanes-Oxley and RegFD and ISS and all these sort of bizarre governance things that have all added up to make it just be incredibly difficult to be public today.

Andreessen, of course, as the lead independent director at Hewlett-Packard, knows all about “bizarre governance things”. But Sarbanes-Oxley and RegFD and ISS don’t even make it into the top ten. And as for the idea that they’re “retaliation against public companies”, that’s just bonkers; in fact, it’s really rather worrying that we have directors of big public companies talking that way.

The three things mentioned by Andreessen come from three different places: Sarbanes-Oxley came from Congress; RegFD came from the SEC; and ISS is a wholly private-sector company which allows shareholders to outsource the job of ensuring that governance at the companies they own is up to par. If there wasn’t significant buy-side demand for such services, ISS wouldn’t exist.

It’s directors’ job to care deeply about governance, rather than to dismiss serious concerns from legislators, regulators, and shareholders as “bizarre governance things”. And for all that companies love to bellyache about the costs of Sarbox compliance, the fact is that if you’re looking to governance issues as a reason why it sucks to be public, you’re looking in entirely the wrong place.

The real reasons it sucks to be public are right there in the name. Being public means being open to permanent scrutiny: you need to be very open about exactly how you’re doing at all times, and the market is giving you a second-by-second verdict on what it thinks of your performance. What’s more, while the glare of shareholder attention on the company can be discomfiting, it tends to pale in comparison to the glare of public attention on the company’s share price. I was on a panel last week talking about IPOs in general and Facebook in particular, and I was struck by the degree to which Mark Zuckerberg’s enormous achievements in building Facebook have already been eclipsed by a laser focus on his company’s share price.

Zuckerberg — or any other CEO — has very little control over his company’s share price, but once a company is public, that’s all the public really cares about. If Facebook’s share price falls, all that means is that external investors today feel less bullish about the company than they did yesterday; if it falls from a high level, that probably just says that there was a lot of hype surrounding the Facebook IPO, and that the hype allowed Facebook to go public at a very high price. Facebook could change the world — Facebook has already changed the world, and did so as a private company — but at this point people don’t care about that any more. All they care about is the first derivative of the share price. And maybe the second.

When companies go public, people stop thinking about them as companies, and start thinking about them as stocks: it’s the equivalent of judging people only by looking at their reflection in one specific mirror, while at the same time having no idea how distorting that mirror actually is. Many traders, especially in the high-frequency and algorithmic spaces, don’t even stop to think about what the company might actually do: they just buy and sell ticker symbols, and help to drive correlations up to unhelpful levels. As a result, CEOs get judged in large part by what the stock market in general is doing, rather than what they are doing.

And meanwhile, CEOs of public companies have to spend an enormous amount of time on outward-facing issues, dealing with investors and analysts and journalists and generally being accountable to their shareholders. That’s as it should be — but it isn’t pleasant. When Andreessen says that it was very easy to be a public company in the 90s, he’s right — but he’s wrong if he thinks the 90s were some kind of halcyon era to which we should return. They were good for Andreessen, of course, who took Netscape public in a blaze of publicity and more or less invented the dot-com stock in the process. But they were bad for shareholders, who saw their brokerage statements implode when the bubble burst. And, as Andreessen rightly says, they were bad for the broader institution of the public stock market, which has never really recovered from the dot-com bust.

As a venture capitalist, Andreessen has a fiduciary responsibility to his LPs, and he needs to give them returns on their investment, in cash, after five or ten years. It’s a lot easier to do that when you can exit via an IPO. But the way to make IPOs easier and more common is not to gut the governance that’s in place right now. Instead it’s to embrace it, and make public companies more like private companies: places where management and shareholders work constructively together and help each other out as and when they can. Mark Andreessen is a very active and helpful shareholder of the companies that Andreessen Horowitz invests in — and he has a level of access to management and corporate information that most public shareholders can only dream of. If he likes that system, maybe he should start thinking about how to port it over to public companies, as well.

Update: See also this great post from Alex Paidas, who’s found a quote from Andreessen saying that all of his companies should have a dual-class share structure. Despite the fact that I can’t ever imagine Andreessen himself being happy with non-voting shares.


I heard Andreessen speak at the Stanford Directors’ College a few weeks ago. In addition to the type of rhetoric you describe he also said that if there was a way to get his money out of startups without going public he’l do it and if he has to go public he’ll only do it going forward the “controlled company” exemption the very specific exemption to exchange rules on corporate governance rules that gave Mark Zuckerberg all the power one his company and his board. Basically the board at Facebook serves at his pleasure.

Reed Hastings, a Facebook board member, said at the same event that he was still trying to decide of that made sense for him, given his philosophy that a board’s most important job was to hire and fire the CEO. If a board member can not take a position adverse to the CEO without the risk of being removed, what’s the point?

I’ve decided Andreessen is good for Andreessen but not so much for the rest of the capital markets.

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Facebook: The List of Incompetents

Felix Salmon
May 23, 2012 14:16 UTC

It’s going to be a long time before the various lawsuits shake themselves out, but one thing’s already clear with respect to the Facebook IPO: absolutely no one has come out of it looking good. It’s worth going down the List of Incompetence here, because regardless of whether any of this was illegal, there are a lot of extremely well-compensated people who, to use a technical term, screwed the pooch on this one.

Top of that list, frankly, is Facebook CFO David Ebersman. The WSJ’s account of his central role in the offering is reasonably definitive: a lot of decisions normally outsourced to banks in the markets were made, in this case, by a tech-company executive in Menlo Park.

Ebersman didn’t make one big mistake, he made three. Firstly, as CFO, it was his job to accurately forecast Facebook’s second-quarter figures, and give the company’s banks a good feel for where they would come in. He failed so badly that he was forced to re-file the IPO prospectus just days before the deal came to market, and to whisper in his bankers’ ears that they should probably cut their forecasts for the company’s revenues.

There’s no excuse for getting that wrong, but if there was an excuse, it would be that Ebersman was too focused on the year-long process of managing an awesome IPO. Ha! He screwed that up, too, of course — not least by upsizing the deal at the last minute, raising the number of shares being sold by 25%. In hindsight, that was a very bad idea. But then, after that, he made his third major mistake: he priced the deal for perfection, at $38 per share, even as big institutional investors — the only ones who knew about the new revenue forecasts — were saying that they had no real desire to own the stock at more than $32 per share. When you’re selling $16 billion of stock, the marginal price-setters are always going to be institutions, rather than price-insensitive retail investors willing to buy Facebook on name recognition alone. And those institutions were never really willing to provide a strong bid above $38.

While most of the blame at Facebook’s end should properly be shouldered by Ebersman, that doesn’t mean Mark Zuckerberg can be let off the hook entirely. It’s his company: the buck stops with him. And he did the IPO no favors at all. First, he insisted on an unprecedented level of individual control over a $100 billion public company; institutional investors never like that. And secondly, he clearly viewed Wall Street and its investors with thinly-disguised contempt, slouching into IPO meetings — when he bothered to turn up at all — in his hoodie, and signally failing to provide the outward-facing leadership that investors crave. Zuckerberg’s refusal to play the Wall Street game is admirable, in some respects — but at the same time is completely inconsistent with a desire to sell $16 billion of shares at a $104 billion valuation.

The third member of Facebook’s leadership team who deserves some blame here is Sheryl Sandberg, the COO, and the person whose job it is to help Zuckerberg navigate the external world. Sandberg also conveniently recused herself from many IPO decisions, which doesn’t seem like a very good idea in retrospect. Either she had too much faith in Ebersman and Zuckerberg to do the right things, and should have been much more involved — or else she was deeply involved, behind the scenes, and therefore responsible for some significant part of the resulting fiasco.

Facebook’s board members and investors look very bad here, too, coming off much more short-term greedy than long-term greedy. Many of them cashed out in the IPO, in a clear sign that they had little faith in the share price going forwards. The board’s job has historically been to rubber-stamp Zuckerberg’s decisions, and to provide him with advice as and when he asks for it. Now, however, the board has a fiduciary responsibility towards all of Facebook’s investors, including the ones who bought in at $45 per share. But there’s no sign that anybody on the board saw the new investors in Facebook as anything more than muppets.

On the Wall Street side of things, the shame list is topped, indubitably, by Morgan Stanley’s technology banker Michael Grimes. He worked hand-in-glove with Ebersman, and all of Ebersman’s decisions can be considered Grimes’s decisions as well. More generally, it was Morgan Stanley’s job to understand exactly what the real demand was for Facebook shares — to sound out investors and price the company just a little bit below what the market was willing to pay. And there’s no doubt that Morgan Stanley failed miserably in that job.

And then there’s the whole scandal of the buried revenue forecasts: the way that Morgan Stanley whispered the new numbers in select clients’ ears, without ever letting the broader investing public know about the downgrade. If you want to develop a reputation as an untrustworthy bank which plays favorites and leaves the little guy out to dry, you could hardly do so in a more effective manner.

The other banks in the deal — JP Morgan, Goldman Sachs, and the rest — don’t deserve quite as much blame as Morgan Stanley, but their actions were more or less identical — they all downgraded their forecasts in secret, and they all went along with the size and pricing of the deal, in return for multi-million-dollar fees. If you bought your Facebook IPO stock from Goldman, you’re going — rightly — to blame Goldman first and foremost if they didn’t tell you about their downgraded forecast. And more generally this deal goes to prove that Wall Street acts very much like a cartel: all the banks behaved in an identical manner, and not one was willing to make a fuss or walk away from a bad deal. They all got stars and dollar signs in their eyes, and behaved like fools as a result.

Then, of course, there’s the Nasdaq. Read Nick Carlson’s interview with an anonymous hedge-fund manager for some of the gorier details here, but in general anything that Nasdaq could mess up, it did mess up. In short: the stock never opened at 11am, as planned, because Nasdaq’s computers weren’t up to snuff. There was a five-minute delay, and then there was a second, 25-minute delay, during which time Nasdaq switched over to a second computer system.

The whole thing turned into a complete disaster. The second computer system didn’t work as planned, and there was an enormous amount of confusion — which still hasn’t been cleared up, in some cases — about where and whether various investors actually managed to sell their stock. As a rule, if you placed an order between 11:05 and 11:30 on Friday, you’re probably in a world of pain today, and you might be relying on the Nasdaq to make you whole for your losses: while you thought you were selling at $42, you might not actually have been able to sell until the shares were at $38 or even less. It seems that the opening price of $42.05 was based only on orders received before 11:05, and ignored all orders after that time, most of which were at much lower levels. Which helps to explain the initial and chaotic plunge in the stock price.

Naturally, when a stock is behaving like that, it takes a very brave investor indeed to dive in and go long at a frothy valuation. And so it’s entirely reasonable to blame the Nasdaq for the failure of the Facebook IPO. It’s their job to get this kind of thing right; instead, they got it spectacularly wrong. End of story.

Finally, there are all the investors, including that anonymous hedge-fund manager, who bought into the IPO even though they knew that the valuation was incredibly high, and are now casting around for someone else to blame for their losses. It’s impossible to feel any sympathy for these people — especially institutions who had no appetite for stock at more than $32 per share, but put in large orders at $38 anyway just because they were counting on Morgan Stanley to give them a nice opening-day pop. If you pay 100X earnings for a hyped internet stock on its first day of trading and then you lose money, you frankly had it coming.

All of which means that the winners in this whole game were you and I: the quiet skeptical masses who simply sat back and watched the farce unfold. In the game of Facebook IPO, it turns out, the only winning move was not to play.


I don’t always trust them as a source (for example, I think these plots are generated from UQDF rather than TotalView), but Nanex has an interesting presentation on the topic showing stuff breaking:


FWIIW, the facebook link thingee I tried to use to log in here wanted to give Reuters access to all my data. Irony.

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The Facebook earnings-forecast scandal

Felix Salmon
May 22, 2012 14:30 UTC

Yesterday, it was the greenshoe — the standard feature of IPOs which also happens to be an officially-mandated case of naked short-selling. Today, it’s another odd special case: the way in which analysts’ estimates of companies’ future earnings are deliberately not made public prior to the IPO — except to select investment-banking clients who are likely to put in large orders for IPO stock.

As Henry Blodget says, this whole episode stinks. It’s almost certainly not illegal. But if you look at the Finra rules about such things, it definitely violates the spirit of the law. For instance, the rules say that Morgan Stanley analysts weren’t allowed to show Facebook their research before it was published — but they don’t say that Facebook can’t quietly whisper in Morgan Stanley’s ear that its estimates might be a bit aggressive. Obviously, there’s no need for the analysts to give Facebook advance notice of their earnings downgrade if that earnings downgrade was a direct consequence of something Facebook told them.

Similarly, Morgan Stanley isn’t allowed to publish a research report or earnings estimates for Facebook within the 40 days following the IPO. But a few days before the IPO? I guess that’s OK — even if the way the estimates were “published” meant they were only available to good friends of the bank.

More generally, the rules ignore the key point here. Retail investors, and the market as a whole, knew when Facebook had its IPO that Morgan Stanley (and JP Morgan, and Goldman Sachs) had research teams with estimates for Facebook’s future earnings. They also knew that those estimates would be made public in 40 days’ time. And if they were sophisticated enough, they probably knew that select Morgan Stanley clients were given access to the analysts and their estimates.

What they didn’t know — what they couldn’t know, because nobody told them — was that those estimates had been cut, significantly, just days before the IPO.

It’s true that retail investors weren’t buying Facebook stock on the strength of the banks earnings estimates, since they didn’t (and still don’t) know what those earnings estimates are. But here’s a material nonpublic fact about Facebook, which retail investors and everybody else in the deal deserved to know: all three underwriters cut their estimates simultaneously, in response to some very minor changes in the revised IPO prospectus.

Here’s Blodget:

Speaking as a former analyst, it seems highly unlikely to me that the vague language in the final IPO amendment would prompt all three underwriter analysts to immediately cut estimates without some sort of nod and wink from someone who knew how Facebook’s second quarter was progressing.

Hot internet stocks like Facebook are all about momentum and growth. Investors expect companies like this to surprise on the upside, occasionally; they get extremely upset, by contrast, when they surprise on the downside. Especially when such surprises come in the immediate run-up to the biggest tech IPO in the history of the world.

Why is Groupon trading 40% below its IPO price? Because people were happy to buy into ramshackle governance and accounting conventions so long as all the lines were going sharply up and to the right. But when you’re trading at massive multiples, any hint of a slowdown in growth, or of failing to meet pretty aggressive targets, is a key sell signal. These companies aren’t supported by fundamentals: they’re only supported by a general atmosphere of aggressive growth expectations and zealous bullishness. When three banks all cut their earnings estimates for Facebook on the same day, that sure ain’t bullish.

This does not mean, of course, that Facebook stock is doomed for all eternity: it could pull an Amazon, and rise sharply out of its post-IPO slump. But this does mean that shareholders should not expect much in the way of transparency or full honesty from a company which is controlled by Mark Zuckerberg personally and which has deliberately created a dual-class share structure in order to to ensure that they can be completely ignored on all decisions. Facebook was whispering in the ears of the lead managers of its investment banks, on the understanding that the results of those whispers would remain available only to select clients until after the IPO was over. That’s not cool. And as a result the company definitely deserves the latest lurch downwards in its (still frothy) share price.


SteveDiamond is correct that it’s securities fraud if material information was ommitted from the S1. Also, it is illegal for management to selectively disclose to analysts material non-public information. Any guidance someone from Facebook gave to the underwriters’ analysts on Q2 and FY2012 would have been material and should have been made public. Further, it is illegal to trade on material, non-public information, which you could argue is what the underwriters and others did through the greenshoe. One might also find that any trades by the clients who were told might be insider trading. Big fat festering pile this is.

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Facebook: The smart money exits

Felix Salmon
May 16, 2012 13:34 UTC

The Facebook IPO is now set to raise an absolutely astonishing amount of money — as much as $18 billion, if the greenshoe is exercised and the offering prices at the top of the indicated range. As a result, it’s certain to be the single largest technology IPO of all time. (Most companies don’t even have a valuation of $18 billion when they IPO, let alone have $18 billion worth of stock for sale to the public.)

So what is Facebook going to do with all that money? Well, it turns out that in upsizing the size of the IPO, Facebook has not actually increased the number of shares it’s selling to the public. Instead, most of the new shares being sold are coming from Mark Zuckerberg personally. He’s now going to sell 126 million shares in the IPO, and other early investors, including James Breyer and Peter Thiel, are cashing out too.

I’ll do the math for you: 126 million shares, at $38 a piece, comes to almost $5 billion. That’s a lot of money to raise in one day. When Facebook first filed for an IPO, Zuckerberg was only selling enough shares to allow him to pay what will probably be the single largest individual tax bill the IRS has ever seen. But now, Zuckerberg’s going to be a billionaire excluding his Facebook stake.*

More generally, this seems to be the point at which the smart money is getting out of Facebook. Accel Partners is now selling 49 million shares in the IPO (think $1.8 billion), while DST and Mail.Ru will sell some $2.5 billion of stock in total.

Capital markets are not particularly efficient, but one thing nearly always holds true: when stock prices are high, companies issue more stock, and when stock prices are low, they issue less stock. In general, we’re not seeing a huge number of primary or secondary offerings right now: it’s still cheaper for companies to issue debt rather than equity. The exception, of course, is in technology companies, where it’s clearly possible to go public at frothy multiples — even if those IPO valuations don’t last long.

The Facebook strategy is an interesting one: a lot of the time, in technology IPOs, you see companies issuing a pretty tiny number of shares, and using artificial scarcity to boost the price. That’s definitely not happening here — Facebook stock is going to be a highly-liquid price discovery tool from day one. And if there are lots of institutional investors out there wanting to own a piece of Facebook at a $100 billion valuation, then frankly you can’t blame Zuckerberg and Accel and DST for taking them up on their offer.

But it’s worth remembering, here, that the main reason that Facebook is going public at all is that it has more than 500 shareholders — and the reason it has more than 500 shareholders is because early investors, including Accel and DST, have been selling down their stakes in private markets for some years now. The main difference between the public markets and the private markets is not the valuations available — $100 billion is very much in line with where Facebook stock has been trading privately — but rather in the sheer volume of stock that can be efficiently sold at one time.

When this IPO is over, Zuckerberg will still have complete control over the company, with more than 50% of the voting rights. But his new shareholders will look very different from his old shareholders, even if the board remains the same. And by far the biggest difference is that while the old shareholders were all sitting on monster paper profits, on their Facebook stock, the new shareholders won’t be. They’re going to want to see the share price — and Facebook’s valuation — go up, substantially. Which means that they’re going to want Zuckerberg to come up with a plan to make Facebook worth $200 billion, or $300 billion, or more.

In order to do that, it’s not going to be enough for Zuckerberg to build a platform: he’s going to have to monetize it, to the tune of way more than a billion dollars a year in advertising profits. Facebook, right now, is trading on its potential for making future profits. At some point, and it’s not all that far away, Zuckerberg’s going to have to realize that potential. Or face some extremely angry shareholders asking whether he played them for suckers when he sold those 126 million shares.

*Update: It now seems that the extra shares being sold by Mark Zuckerberg are not shares he owns, but rather shares he doesn’t own. Zuckerberg has an “irrevocable proxy” over certain shares, which means that he controls them without owning them. He seems to be selling those shares, not shares he owns pesrsonally. So he won’t personally receive the extra billions.


Mr.Zuckerberg made out like a pirate in a black hoodie, good for him, but its looks like the cats finally out of the bag for Facebook stock, as for it being hype, the whole stock market exchange is built on hype or chance

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Chart of the day, Facebook IPO edition

Felix Salmon
Feb 14, 2012 16:49 UTC

There are two ways of looking at the $5 billion or so that Facebook is going to raise in its IPO. One is to ask what on earth the company is going to do with all that money: it’s already making substantially more in the way of profits than it is likely to want to spend, and the chances are that the $5 billion is just going to go straight into the bank, where it will earn roughly 0.77% per year. This is not the best use of shareholder funds, and it’s hard to see why Facebook’s CFO would want the cash pile to be any bigger.

On the other hand, $5 billion is very small as a percentage of Facebook’s market capitalization. Here’s Allan Sloan:

If Facebook’s offering ends up being the advertised $5 billion, and the company’s stock market valuation is in the expected $75 billion to $100 billion range, it means that only 5 to 7 percent of the company’s shares will be available to public investors.

While there are all sorts of rationalizations for having such a small public offering relative to a company’s size, the real reason, as any Street insider will tell you, is to create an initial shortage of stock so that the share price runs up when public trading starts.

It’s not enough for Mark Zuckerberg & Co. to have created an amazing, incredibly valuable company over an incredibly short period. They feel the need to use this tacky market trick to drive up Facebook’s value even more.

Sloan has a point, here: it’s very rare for companies to go public while selling less than 10% of their stock. Here’s a chart from Thomson Reuters, showing the free float at IPO for all US issues from 1/1/2000 onwards which had a market capitalization at IPO of more than $1 billion.


As you can see, it’s very rare to go public with a float of less than 10% of the company: the average for tech companies is 19%, and the overall average is 26%.

And if you look at IPOs which raise more than $500 million, the percentages get bigger still: if you’re raising more than half a billion dollars, then tech companies end up with a free float of 34% of their company, on average, while overall, companies float 43% of their shares.

So, is Sloan right? Is Facebook’s small free float a “tacky market trick”?

My feeling is that it isn’t — and that it’s rather a function of the way in which Facebook stock is distributed. Since the company doesn’t really need to raise equity capital, the only other way to increase the free float is to persuade existing shareholders to sell their stock into the IPO. Mark Zuckerberg certainly doesn’t want to do that — to the contrary, he wants to retain as much stock and control as possible. And most of his fellow shareholders are similarly rich and fond of their stock, preferring to wait a while before selling.

In other words, what we’re seeing here is the natural consequence of what happens when the stock market essentially forces companies to be profitable before they go public. In the olden days, when companies went public because they needed the money, they would sell quite a lot of stock. Today, that’s no longer the case, especially in Silicon Valley, where capital-raising rounds are generally done privately, with VCs. If Facebook hadn’t been able to raise well over a billion dollars privately, then it might have gone public earlier, selling more of its stock in the process. But given the way that equity investing in early-stage companies has moved from the public to the private markets, what we’re seeing is pretty normal, and not really a tacky market trick at all.


Anybody who buys stock in a company where the founder retains voting control and ivnestors have no ability to oust management is a fool…

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Why Groupon won’t raise its IPO price

Felix Salmon
Nov 3, 2011 15:31 UTC

Dan Primack gives three reasons why Groupon isn’t going to raise its IPO price by a buck or two today. The most important is #2: Groupon really wants to allocate shares to people who aren’t going to simply flip them on day one. If it can use a slightly lower share price to attract long-term buy-and-hold investors, it’ll happily do so.

But that’s a big “if”. And in fact keeping the offer price low will only serve to increase the size of the first-day pop, and therefore maximize the incentive for investors with an IPO allocation to flip their shares rather than hold onto them.

My feeling is that there are three other, more important reasons why Groupon would keep the IPO price low.

The first is that first-day pop. A lot of people think of such things as an indication that the IPO was mispriced, and that the IPO’s bankers left money on the table. But for Groupon, the single most important feature of this IPO is that it be seen to be a success. Groupon has had worse press in the past few months than any pre-IPO company I can think of — it’s been absolutely hammered. It’s worse even than Glencore! The IPO is Groupon’s opportunity to demonstrate that there’s still a lot of demand for equity in a high-flying, fast-growing discounter. And the best way to do that is to get lots of headlines about the big rise, in percentage terms, that the IPO saw on its first day of trading.

Secondly, there’s the small float. Groupon’s only offering 30 million shares, which means that a dollar rise in the IPO price would get it less than $30 million in new money. That’s a rounding error for Groupon.

Finally, and most importantly, Primack’s article is based on the premise that “oversubscription typically leads to a price range increase, particularly at a company like Groupon that could really use the cash”. But Groupon has been shouting until it’s blue in the face that it doesn’t need the IPO cash, that it’s fine on the cash front, that the IPO is just a way of going public, and is not really about the money-raising at all.

If Groupon were to raise its IPO price now, that would certainly be seen as an indication that it does need that extra $30 million or $60 million after all. And that’s the last message that Groupon wants to send to the market, on this of all days.

So expect Groupon to price at the top of the indicated range of $16 to $18 per share. And then to have a healthy pop when it opens for trade tomorrow morning. That’s what Groupon’s hoping for, anyway.

Update: Groupon prices at $20. So much for my theories.


They’ve just priced them at $20, Felix. You shouldn’t underestimate the greed of companies that really have no sustainable business model.

And if there’s a big pop, people will definitely be flipping their shares. And I doubt if Groupon will care about that.

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Chart of the day: When U.S. companies IPO abroad

Felix Salmon
May 27, 2011 03:58 UTC

As I secretly hoped that he might, Guan came to the rescue and provided me with exactly what I was looking for — and with Thomson Reuters data, no less! (It comes from SDC Platinum, I should probably befriend someone there.) I wanted a chart of the ratio of foreign IPOs to domestic ones, for U.S. companies, on a rolling five-year basis, to see whether the current level around 10% constitutes a big spike upwards. And the answer is that yes, it does:


Guan cautions that the data from before 1980 or so might not be particularly reliable, since it’s hard to know when a U.S. company lists abroad unless you’re a truly global company. But that doesn’t really matter: the proportion of IPOs of U.S. companies which took place abroad only cracked 2% for the first time in 1999. It stayed between 1% and 2.5% all the way from 1998 through 2004, and then it suddenly started spiking: 7.1% in 2005, 8.4% in 2006, 9.3% in 2007, and a whopping 15.7% in 2008, when 6 companies had IPOs abroad and only 38 managed the feat domestically.

On an absolute rather than percentage level, the record year was 2007, when there were 24 foreign IPOs; there’s a three-way tie for second place, with 17 foreign IPOs in each of 1999, 2005, and 2006.

In any case, the thick blue line is what I was looking for, and it’s going up and to the right about as fast as any five-year moving average is ever likely to.

My next project, which maybe I can find someone at SDC Platinum to help me with, is to have a look at all those U.S. companies which had an IPO abroad — there are 157 of them, altogether — and work out how many of them ended up getting a fully-fledged US listing. Could a listing on, say, London’s AIM end up being a reasonably common bunny slope for U.S. companies which want a cheaper and gentler introduction to the world of being public than a major listing on the New York Stock Exchange?


FYI, the image doesn’t show up in firefox, only the .png file name.

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The LinkedIn IPO debate

Felix Salmon
May 23, 2011 06:57 UTC

In the blue corner, we have Joe Nocera and Henry Blodget (twice). In the red corner, there’s The Epicurean Dealmaker (twice), with The Analyst as cornerman. The debate centers on the fact that the shares LinkedIn sold Thursday are worth hundreds of millions of dollars more than LinkedIn received from its bankers. To Nocera and Blodget, the conclusion is clear: LinkedIn’s bankers screwed the company out of that money, giving it instead to their favored buy-side clients.

There’s no doubt that investment bankers deliberately underprice IPOs. Blodget explains why:

If underwriters aimed to price each IPO exactly at fair-market value, there would be no incentive for institutions to take the risk of buying the stock before the shares started trading. Instead, they’d just wait to see where the stock traded and then make their buying decision then.

In the case of an oversubscribed IPO like LinkedIn, this isn’t completely convincing — getting a large allocation of shares at once is preferable to having to taking your chances with respect to being able to cobble together a significant position in the secondary market. After all, as TED says, the banks “want to weight the initial buyers in the deal toward investors who intend to not only hold the stock after it frees to trade but also add to their positions in the aftermarket”.

But the bankers don’t only want to place stock with high-quality long-term investors; they also want to achieve one of the main purposes of going public in the first place, which is price discovery. For that, you need a substantial volume of buyers — and sellers — all day every day for years and decades to come.

In other words, it’s the market which sets the price of the stock; it’s the job of the bankers to bring the company to market. And the bankers only have room for error in one direction. They can underprice the IPO; in fact, they have to underprice the IPO by some amount. But they can’t set the price too high.

Now the view of Nocera and Blodget is that the bankers can or should have a very good idea where the shares are going to end up trading, and that therefore if they end up underpricing the IPO by as much as we saw on Thursday, that’s unprofessional at best and downright theft at worst. Nocera says that the LinkedIn bankers “absolutely must have known” that the IPO was going to double in price; Blodget says that “Wall Street underwriters are paid massive amounts of money to estimate fair-market value, so they deserve to be held accountable when they blow it.”

I agree with Blodget’s premise here, but I come to a different conclusion. The whopping 7% fee that banks charge for an IPO is indeed a very large sum of money; if markets were remotely efficient, that fee would be much smaller, closer to the kind of fees normally seen on bond issuances, which can be less than 0.2%. Or, you can consider the 7% fee to be the cost of a guarantee that the company will get analyst coverage from the lead managers for the foreseeable future, rather than the price of market expertise which costs much less in other contexts.

In any event, I disagree with Blodget and Nocera that the banks knew what was going to happen when LinkedIn went public, and generously gifted hundreds of millions of dollars to their clients rather than giving 93% of that sum to LinkedIn and keeping the rest for themselves.

For one thing, if the large 7% fee does anything, it aligns the banks’ interests with the issuer’s. If the banks felt they could make millions more dollars for themselves just by raising the offering price, it’s reasonable to assume that they would have done so. I’m sure that the institutions which were granted IPO access are grateful to the banks for the money they made, but that gratitude isn’t worth a ten-figure sum to the ECM divisions of the banks in question.

But there’s an even easier way to prove that the banks didn’t know what was going to happen on IPO day. Which bank, after all, is the greediest and most knowledgeable of them all? Goldman Sachs. And Goldman was one of the few investors which sold its entire position at the IPO price of $45 per share. If Wall Street knew that LinkedIn was going to soar into triple digits on day one, you can be quite sure that Goldman would have held on to most if not all of those shares.

This, then, looks much more like a cock-up than a conspiracy. If the banks knew that they could get the IPO away at $80 per share and still see a 15% pop, they would surely have done so. But they didn’t know that, because LinkedIn was the first social-networking company to go public, and therefore no one — on either the buy side or the sell side — really had a clue where the public markets would end up valuing it.

And indeed it’s not entirely clear that the banks could have gotten the IPO away at $80 per share. The way that the LinkedIn IPO worked, the shares were issued at $45 to investors who were happy to hold them at that level; those investors then started selling when the first-day pop reached insane proportions. At $80 per share, however, very few of those investors would have been happy to hold on to the stock for the long term — which means they wouldn’t have put in bids in the first place. The banks might well have had serious difficulty even allocating the shares in the first place, and would have been risking a busted IPO.

What’s more — and this is a point which, weirdly, neither TED nor The Analyst have made — bankers and investors actually had a very good idea what the market price for LinkedIn shares was. It was $35 per share. LinkedIn was the fourth-most-traded stock on SecondMarket, with an auction every month from April 2010 through March 2011. In January there was a significant pop to $34 per share, and then it stayed there: in February the auction cleared at $35, and in March it was the same amount.

Yes, the LinkedIn prices were arrived at with only a small number of buyers and sellers, but they were real market prices in an anonymized market; pricing well above the SecondMarket level was always going to be dangerous. The bookbuilding process is vague and error-prone compared to the hard numbers being generated on a monthly basis on private markets, and so bankers were naturally going to trust SecondMarket as a very important datapoint in their pricing decisions. If LinkedIn had priced well below the SecondMarket price and then popped up to exactly that level, then it would have been easy to criticize the bankers. But instead it priced at a 30% premium to the highest-ever SecondMarket price — which was pretty aggressive, I think.

The SecondMarket story also shows that auctions often don’t work very well. There’s a 50-page paper here explaining all the reasons why that might be, especially when it comes to initial public offerings. But this is an important point: the Noceras and Blodgets of this world are very quiet on the question of whether there’s a better way of doing things than the one we’ve got right now.

Auctions have been tried, in many markets and jurisdictions around the world, and they’ve always failed; attempts to improve them have been unsuccessful, largely because it’s pretty much impossible for underwriters to distinguish between investors who have done their homework and know exactly how much they want to pay, on the one hand, and free-riders who add a lot of noise to proceedings, on the other, who trust in the former group to get the pricing right. On top of that, the mathematics of the winner’s curse means that bidders have to be extremely sensitive to the number of other bidders in the auction — and that is a number they’re unlikely to know.

And yet I’m not completely on board with the people who think that everything’s fine. Consider the point is made by The Analyst, that the only people complaining, here, seem to be kibitzers in the press. The bankers, the sellers, and the buyers are all happy — so what’s not to love? Here I think Nocera and Blodget are on stronger ground, because of the slightly invidious way in which IPOs are set up.

Essentially, there are two types of stock sale, generally known as primary and secondary, although “secondary”, in particular, can have different meanings. What I’m talking about here is the distinction between primary offerings, where a company sells shares in itself; and secondary offerings, where shareholders sell stock to each other. Rights issues are primary offerings, even if they’re not IPOs, while a founder selling stock in the market would be considered a secondary offering, even though such activities are generally done very quietly.

The LinkedIn IPO was, like most IPOs, mainly a primary offering — LinkedIn itself sold most of the shares, and received most of the proceeds. Insofar as those shares were underpriced, LinkedIn was the victim. Now LinkedIn is owned by many shareholders, who can be considered victims proportionally to the number of shares that they own. If I own 1% of LinkedIn, and the company left $200 million on the table, then $2 million of that money can be considered mine.

But the fact is that if I own 1% of LinkedIn, and I just saw the company getting valued on the stock market at a valuation of $9 billion or so, then I’m just ecstatic that my stake is worth $90 million, and that I haven’t sold any shares below that level. The main interest that I have in an IPO like this is as a price-discovery mechanism, rather than as a cash-raising mechanism. As TED says, LinkedIn has no particular need for any cash at all, let alone $300 million; if it had an extra $200 million in the bank, earning some fraction of 1% per annum, that wouldn’t increase the value of my stake by any measurable amount, because it wouldn’t affect the share price at all.

In that sense, the extra $200 million, while having a huge amount of value to the lucky investors who got to buy in at the IPO price, is actually worth very little to LinkedIn’s shareholders. If markets were wondrously efficient, that $200 million in cash would be reflected in a share price being $2 higher. In reality, the people buying the shares at this level really don’t care how much money LinkedIn has in the bank — especially now that it has a much stronger acquisition currency, should it want to start buying other companies, in its own stock.

As a result, almost none of the “losers”, here, bar LinkedIn’s corporate treasurer, really cares about that money. LinkedIn’s shareholders care about the share price, and the amount of money that LinkedIn has is irrelevant to the share price. LinkedIn’s managers and executives care about the fundamental business, not about trying to manage a cash pile which was already very large and is now significantly larger. The only real losers are the investors in Goldman Sachs’s fund — I suspect they’re rightly very angry about the company’s decision to divest itself of its entire stake at $45 per share.

Meanwhile, the big winners — the funds given access to the IPO — are ecstatic. But those funds did nothing, really, to deserve their windfall. Early-stage investors in the company were taking big risks and locking up their money for years; the people who got IPO allocations were taking no risk at all and locking up their money for, oh, a few minutes.

It would be wonderful if there were a better, fairer way of running IPOs, which didn’t give Wall Street banks the power to make millions of dollars overnight for their well-connected friends. But many attempts have been made to find such a way, and none of them have really caught on.

And here’s where SecondMarket could come in handy. Companies wanting to go public could simply lift most of the restrictions on who can buy and sell company stock on SecondMarket, SharesPost, and other private exchanges — including any restrictions limiting the number of shareholders to less than 500. At that point, under SEC rules, the company would be making a clear statement that it intended to have a fully-fledged listing the following year. It could file an S1, and maybe release some shares of its own onto the private markets just to improve liquidity and price discovery.

Then, a few months later, the company would officially sign up with Nasdaq or the NYSE, and let its shares be listed, possibly in conjunction with another tranche of newly-issued shares coming to market at the same time. Because a large number of shares had already been trading in a quasi-public market for months, there probably wouldn’t be nearly as much room for pricing error as there is now. There needn’t even be a big official IPO; that would be up to the company and its bankers.

Many companies, of course, love seeing their name splashed across the Corinthian columns of the NYSE, and having their executives ring some bell or other to celebrate their listing. All that pomp and ceremony is worth something — as is the press coverage which comes with it. A fairer way of going public would necessarily mean that IPOs would become much less momentous events. Which is why I suspect that we’ll stick with the old-fashioned way for the time being. Even if it means dumping hundreds of millions of dollars into the laps of investors who really don’t deserve it.


You have such repeated, insistent, conviction that “price discovery” is the justification for many things financial but it always seems as though you treat this as something obvious and in no need of any explication. One day, please, could you spend a bit of time telling us what you are really thinking when you invoke this concept?
E.g. Do you think there is an objectively “correct” (or economically useful/efficient) price being “discovered” somehow? (If so, how do you reconcile this with e.g. such high volatility in the public markets as we have seen over the last two years, or the periodic huge disconnect between private and public valuations?) Or do you just mean “a price near where there is substantial two-sided liquidity”? (In which case, don’t you think you over-praise its significance … I’m thinking in particular of various of your CDO posts).
In this post you say: “But the bankers … also want to achieve one of the main purposes of going public in the first place, which is price discovery?”
Do they really consciously _want_ this? I perhaps see it if it means merely “create a liquid market”, but wanting something beyond this? (Cynically: if their bonus isn’t tied to something, can a banker really _want_ something?)
And about a hypothetical insider already owning some of the company you say “The main interest that I have in an IPO like this is as a price-discovery mechanism…”. Surely no! My main interest is the IPO creating a liquid venue where I can sell my stake at a high-price when I want to. The higher the better. I’d be pretty sad if the market “discovered” a $1 price per share, and being told what a surprising discovery this was would not mollify me. Again, unless you mean something extremely shallow
by the term “price discovery”.

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