The media frenzy over Facebook's IPO has a lot of people wondering how the process works and how well it's going, even though most small investors won't be able to get in on the opening day action.
When a company like Facebook sells shares to the public, its stock is bought in an open market that seems a lot like purchasing something on eBay. But the process of getting those first shares to market is a lot more complicated than uploading a picture of that guitar your son never used.
Here’s a rough guide to one of the biggest initial public offerings – or IPOs – in stock market history.
What’s an underwriter, and why do companies need them to go public?
Because the process has so many moving parts, companies typically hire experts, in the form of investment bankers, to help them handle the details and advise them. On the day the stock is finally sold, the underwriters act as middlemen, buying shares directly from Facebook and then selling them to investors. They keep a piece for themselves, of course.
Morgan Stanley got the nod as lead underwriter for Facebook, a role that gives the firm the biggest piece of the offering, prestige that could help attract new business and the honor of top billing on an offering announcement known as a "tombstone." Another 30 or so banks will help distribute the stock to investors on the day of the offering.
Why does it take so long to arrange the offering?
To go forward with its offering, Facebook has to spell out to potential investors exactly what they’re getting in a document filed with the Securities and Exchange Commission, known as an S-1. It's the first of many filings the company will have to make once its shares are in public hands. The S-1 also becomes the formal offering document, or prospectus. Typically, the underwriters and SEC go back and forth on several drafts, making changes until both sides are satisfied. So far, Facebook is on its fifth filing and the S-1 weighs in at more than 200 pages.
In its S-1, Facebook offers details of its financial condition and management structure, includind the names of its top executives, how much they make and how much stock they hold. The law also requires Facebook to spell out numerous “risk factors.” Some of them are fairly routine (“Unfavorable media coverage could negatively affect our business.”) Some of them are not so routine (“Yahoo is suing us for patent infringement.”)
The reason for all of this candor is more than altruism. If the company gets into financial trouble for reasons it hasn’t disclosed in the prospectus, investors can sue.
Doesn’t that just scare off potential investors?
That’s why companies going public stage a “road show” – a series of meetings with underwriters and potential investors to drum up interest in the stock. These are usually a series of lunches with PowerPoint presentations touting the company’s successes and laying out its bright future. Facebook hit the road this week after posting a 30-minute video featuring gushing monologues by CEO Mark Zuckerberg and other company principals explaining how Facebook, with its 900 million monthly users, plans to become nothing less than the flywheel of global commerce. (Click here to watch the video.)
Apparently, the video wasn't ready for prime time. Though senior managers adhered to a strict Silicon Valley dress code as they described the brave new world they’re creating, there was plenty to make a stodgy investor comfortable, including talk of “inflexion points” and a “compelling value proposition.” After the presentation bombed in its New York opening, it was scrapped on the road in favor of a more conventional live presentation.
OK, I’m sold. How can I get in on the ground floor?
You can't. Not unless you’re a large institutional investor like a pension fund or your stock broker is unusually well plugged into one of those 30 underwriters. Facebook plans to sell 337 million shares – which sounds like a lot. But because it’s widely expected to be a hot stock (after all, it’s going to be at the center of global commerce forever), demand is likely to be much bigger than the first batch of shares.
Why not sell more shares? Wouldn't Facebook make more money?
In Zuckerberg’s case, the more stock he sells the less control he has over the company. And Facebook’s CEO will retain an unusual level of control over the company he founded.
Unlike most public companies, Facebook has set up two types of stock with different rights to vote on decisions about the company’s business. Class A shares, which the public can buy, get one vote each. Class B shares, some 28.4 percent of which are held by Zuckerberg, get 10 votes apiece. Facebook’s 27-year-old CEO has also made side agreements with other Class B holders, giving him control over their votes, for a total of 57 percent of the voting rights after the IPO is completed. If Class B holders sell their stock, those shares revert to one-vote Class A shares, which could concentrate Zuckerberg’s control even further over time.
For the underwriters, there’s always the risk that if the offering is too big, they may misjudge demand and get stuck with unsold shares. That rarely happens. When it does there’s usually a clause in the deal requiring the company to buy shares back. In Facebook's case, Morgan Stanley also has the right to sell another 50 million shares if it sees strong demand. (On Wall Street, this is called the “green shoe” option – named for the company that first allowed this in 1960.) By adjusting the number of shares of the initial offering, the underwriter can exert some control over the first-day pricing.
So how much will the stock go for on Day One?
Facebook says in its latest SEC filing that the stock will be priced somewhere between $28 and $35 a share, raising up to $13.6 billion. That would value the company at a total of $77 billion to $96 billion. The exact amount will be set after the stock market closes on the day before the offering, based on market conditions and the underwriters' best guess on how much demand there will be. The company's ticker symbol is expected to be FB.
Pricing an IPO is something of an art. If you price it too low, and the stock soars the next day, you’ve left money on the table. If you price it too high, and the stock falls, your company’s stock is widely seen as a dud.
Who makes money from the IPO?
A lot of people. First, Facebook stands to rake in an estimated $5.8 billion on the 180 million shares it will be selling from its treasury. That money can be used for general operating expenses, research and expansion. In theory, that’s the reason companies go public in the first place.
The rest of the shares are being sold by individuals – managers, employees, early stage investors – who were given stock valued, in some cases, at a tiny fraction of a cent. Expect a flood of stories about the exploits of Facebook’s suddenly wealthy 20-something employees. Not everyone can cash in right away; like most new companies, Facebook puts restrictions on some stock awards the prevent them from all coming to market at once and forcing down the share price.
If all goes well, the inner circle of well-connected institutional and private investors will also profit from the “first-day pop” in the price once the stock begins trading. Even if the stock settles only modestly higher than the offering price, it’s not a bad one-day return.
And the underwriters will get their piece, though in Facebook’s case it will be relatively small. Underwriters typically take home as much as 7 percent of the value of the offering in fees, commissions and the spread between what they pay the company and what they charge investors. But in competing so fiercely for the company’s business, Morgan Stanley apparently gave Zuckerberg a terrific deal. According to published reports, Facebook will pay a little over 1 percent of the offering’s value to get its stock in public hands.
That should be worth at least a “Like” from him on their Facebook page.