Practical analysis for investment professionals
01 March 2012

Three Questions about the Facebook IPO

Unless you have been living under a rock, you must be aware that Facebook, the “darling” of social media, is about to go public. The unprecedented amount of attention that this IPO has received is creating a hysteria among investors, who are clamoring to own a piece of this Silicon Valley phenomenon.

But before investors slake their thirst for Facebook shares, market participants should consider these questions:

  1. How will the shares Facebook issues be distributed?
  2. What are the rules and regulations that must be followed?
  3. What are the ethical standards that should be followed?

Distribution of Shares

Traditionally, the issuing company and its investment banks have controlled the IPO process. Because of the risks the bankers assume as underwriters, they are generally responsible for setting the initial price of the shares and deciding the percentage that will be allocated to institutional and individual investors. For oversubscribed or “hot” IPOs, a patronage system has developed: the banks use these shares to reward their favored clients (i.e., large revenue generators) and to generate additional corporate finance business. Think, “I’ll scratch your back if you scratch mine!”

As a result, first seating at the IPO trough usually goes to the banks’ institutional clients (mutual funds, pension plans, hedge funds). The underlying rationale is that these clients are more likely to purchase large blocks of shares and are less likely to flip them when the shares start trading in the aftermarket.

The second round of seating (i.e., the leftovers) goes to the banks’ individual or retail clients. Whether an individual client actually receives shares, as well as the number of shares they receive, depends on the power and status of their investment adviser at the bank. According to An Objective View, three factors will determine whether investment advisers, and their clients in turn, get shares in a hot IPO:

  1. Size and nature of the adviser’s book: The larger the adviser book of clients and the more revenue he/she is able to generate for the firm (usually through the sale of high margin products), the greater the likelihood that the adviser will receive shares.
  2. Quality of relationships: The longer the adviser and client have been with the firm, the greater the likelihood that the adviser will receive shares.
  3. Consistency in new issue participation: The more IPOs the adviser has sold to his clients, the greater the likelihood that the adviser will receive shares.

In other words, those advisors and clients who generate the most profit for the bank will probably get shares.

This type of patronage system was standard until 1995, when the Boston Beer Company went public. Jim Koch, founder of the Boston Beer Company, had the heretical notion of putting his loyal beer-drinking customers first by selling shares in the company directly to them. Even more sacrilegious, these customers were able to purchase the shares at a lower price ($15) than the opening price in the offering ($15 to$20).

Why would anyone want to do such a thing? According to Koch, “It’s good for a company if its shares are in the hands of the people who really believe in it — and for us that means the people who really love Sam Adams beer.” William R. Hambrecht, a Silicon Valley venture capitalist, helped Koch structure the IPO and since then has developed a modified Dutch auction IPO model that was used most famously by Google in 2004 and Morningstar in 2005.

So, Mark Zuckerberg, wouldn’t it be great to bestow some largesse on your loyal Facebook subjects by giving them an opportunity to purchase shares in the company at favorable price? It is not too late to make this happen.

Legal/Regulatory Requirements

On 27 May 2011, FINRA Rule 5131 became effective. This rule is “intended to sustain public confidence in the initial public offering (IPO) process by establishing specific and detailed regulation requirements with respect to the allocation, pricing and trading of new issues.” Some of the activities that the rule prohibits include:

  • Quid pro quo allocations. Firms are prohibited from using an IPO allocation in order to obtain a kickback from the recipient in the form of excessive compensation for other services.
  • Spinning. Firms are prohibited from allocating IPO shares to executive officers, directors, and certain former or prospective investment banking clients. IPO shares previously have been used to thank investment banking clients for their prior business and to encourage prospective clients. The new rule also requires firms to establish, maintain, and enforce policies and procedures that will prevent investment banking personnel from indirectly or directly influencing or being involved in their firm’s allocation decisions.
  • Levying penalties on flipping. In an effort to stop the bias against allocating shares to individual/retail clients, the new rule prohibits firms from penalizing investment advisers whose clients sell the IPO shares they were allocated soon after the shares are publicly traded.
  • Acceptance of market orders. Investment advisers are no longer allowed to solicit or accept market orders for the purchase of IPO shares in the secondary market prior to the start of trading. Instead, clients can only place limited orders for these shares. Previously, if investors were not allocated shares in the IPO (or did not receive the total number of shares they wanted), they would place a market order for the shares before the first day of trading. In many cases, however, the price at which the shares initially traded in the secondary market was far above the IPO price and way beyond what the investor had planned to pay. For example, an IPO price may have been $25, but when the shares began trading in the open market, the initial market price may have risen to $70.

To increase the transparency of the book building and allocation process, Rule 5131 also requires underwriters to prepare an indications of interest report and a final allocations report. The indications of interest report contains the names of institutional investors, the number of shares indicated by each one, and the aggregate demand from retail investors. Similarly, the final allocations report contains the number of shares allocated to each institutional investor and the total shares allocated to retail investors.

Underwriters are also required to follow Rule 101 of SEC Regulation M under the Securities Exchange Act of 1934. This rule prohibits underwriters from engaging in any activity that could artificially influence the demand for the new issue in the secondary market, such as:

  • Asking clients whether they intend to place an aftermarket order for IPO stock and in what quantity.
  • Telling clients that purchasing shares in the aftermarket would help them get allocations of hot or oversubscribed IPOs.
  • Encouraging customers that have indicated an interest in aftermarket purchases to increase the price they would be willing to pay for the shares in the aftermarket because other customers had provided higher after market price limits.

Can you believe that these things were occurring before they were prohibited?

Ethical Issues

As investment professionals, there are a number of ethical issues that we need to consider when participating in IPOs, for our clients as well as for ourselves. In order to maintain our independence and objectivity and minimize conflicts of interest, we should avoid or at the very least minimize our personal participation in equity IPOs, especially those that are oversubscribed.

In the current environment perceptions can be as damaging as the actual truth. Therefore, participating in a hot IPO for our personal account may give the appearance that we are taking away an attractive investment opportunity from our clients and placing our interests ahead of theirs. Clients may also feel that we are being incentivized to make future investment decisions for the benefit of the firm that allocated the shares to us.

We also have a duty to deal with our clients fairly and objectively, which means that we should distribute new issues to all clients for whom it is appropriate and in a manner that is consistent with our firm’s policies for allocating blocks of stock. Most firms have or should have formal policies and/or procedures to ensure that conflicts of interest and other ethical issues are identified and appropriately managed. For example, some firms require prior approval for employees to participate in an IPO as well as the disclosure of investment actions taken when the shares begin trading in the aftermarket.

As the date of the impending Facebook IPO nears, it will be fascinating to watch all of the machinations that will no doubt take place surrounding the allocation of shares, as well as what happens on the first day of trading. It will be like a Black Friday sale.

About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of Ethics and Professional Standards at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

3 thoughts on “Three Questions about the Facebook IPO”

  1. Michael,

    I participated in IPOs in the 1990s, when all of these prohibited activities were part of institutional investing. I also recall that institutional salespeople fought tooth and nail for commission allocations, another patronage system of epic proportions.

    In this day and age, there has to be a better way. Surely the same technology that created Facebook could be used to raise equity capital in an ethical manner.
    Rob

    1. Rowan Williams-Short says:

      Hi Michael

      Thanks for a well thought out article. As I would expect, you have addressed the ethical aspects of the IPO succinctly and interestingly.

      However I differ with you on the notion that faithful FB users would be well served by being treated as loyally as were the consumers of Sam Adams.

      The FB listing stuns me, coming within less than a generation of the lamentable TMT episode. Obscene valuations for a widget whose lifespan might not be all that long (low barriers to entry, easily surpassed by newer technology and so on) beget disasters.

      If, as you hint, Mr Zuckerberg arranges preferable allocations to FB customers, he may end up feeling quite rubicund about his largesse, if the share price succumbs to crazy valuations and suffers the fate of so many enfeebled TMT shares of yesteryear.

      Maybe he should rather reward users’ loyalty by banning them from the IPO!

      Regards,
      Rowan

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