John Hempton at Bronte Capital often makes for an interesting read. Today, however, I have to disagree with his take on the ethical obligations of investment bankers in the Facebook IPO. (Facebook and the sad case of ethical investment bankers).

John writes:

“In an IPO an investment bank takes a fee from a business to place that stock in financial markets. Or, more precisely, they take a fee from a business to sell part of that business. Their customer is the company doing an IPO and they have a legal and moral obligation to get the highest price for the company they are selling. No more. No less . . .

The investment bank owes a duty to the seller of the IPO and that is all.”

I believe that statement is quite an oversimplification.

Perhaps it is the corporate attorney in me, but good counsel offered to firms going public needs to be more nuanced than “maximize price – period.” After all, IPO pricing is as much art as science; merely generating the highest IPO proceeds at the expense of every other factor is likely to be short-sighted.

Said another way, it may not be in the best interest of the company to say the hell with everything else, lets top tick our price at the IPO. (I will ignore the selective disclosure issues in order to stay focused on the IPO pricing issue in this exercise).

If I were Facebook’s iBanker, my ethical obligations would have included having a sit down with the company’s senior management team prior to going public, and offering up the following counsel, emphasizing these 3 points in particular:

“Folks, you have built a tremendous internet company in a very short time. Your brand recognition and reach are enormous, and the public perceives you as a (mostly) positive force in their lives.

However, there are a few issues that need to be resolved — some hair on the deal. Rather than detail all of them, let’s discuss three.

1. Pre Public: Let’s begin with the issue of all the publicly traded shares pre-IPO. You have practically gone public already given the extensive number of non-employee, non-venture backing shareholders you have; note that these public sales occurred without the usual legal disclosures, accounting statements or risk statements. These markets are opaque in terms fees and costs, lack full transparency as top pricing. This is why what they do cannot safely be called “price discovery.”

Thus, you have a growing class of shareholders who are uninformed about youre company and its prospects.

2. Valuation: The second issue stems directly from all those private and seemingly uninformed buyers — and that is the valuation. By any conceivable measure, the prices at which shares were changing hands in the private market were extremely rich. With revenues at $4B, and profits at $1B, pre-IPO, you are trading at 28X sales and 100X earnings. Just as a comparison, firms like Microsoft, Apple and Google all went public at 4-5X sales and 25X earnings.

3. Long Term Relationship with Your Investors: The buyers of your stock are looking to grow with the company over the next 5, 10, or even 20 years. The dual class structure is a red flag to many of the potential investors, and your pricing is the other. If you do not want a relationship with the mutual funds, indexes, and individual investors who are the potential long term holders of your stock, then why are you going public?

Even after this liquidity event, you are still very substantial owners of stock in Facebook. Have the patience to grow into your valuation, rather than trying to ring the bell at your IPO . . .

That is the advice I would have given.  Alas, we don’t know if such counsel was ever shared with the management team, but we do know that it (or anything like it) was not taken.

Here we are, several weeks post-IPO, and the stock is down 26%, trading for under $28.

Not only has the debacle dissuaded all sorts of investors from holding this issue, it may have even damaged Facebook’s brand. We probably won’t know the complete impact of the botched IPO’s total fallout until year’s end.

Meanwhile, Facebook’s stock continues to grope for a floor. My best estimate of fair value is when its in the teens — just like most of its users average age . . .

Category: IPOs, Really, really bad calls, Technology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

16 Responses to “What Were iBanker’s Ethical Obligations to Facebook?”

  1. InterestedObserver says:

    I’d agree that one can make a decent case that fair value is in the teens…, somewhere. However, that seems to require that FB do everything right for a couple of years (there is a decent history that this is achievable with their team), but it seems to underweight the barrier to entry risk, which for this business seems exceptionally low (c.f. MySpace, Friendster, etc.)

  2. Herman Frank says:

    Too bad that ONCE AGAIN you’re “the sound and medium- to long term thinking person, i.e. the grownup”! Alas! The investment bankers associated with the “secondary offering of FB” are the short-term “grab the money and run”-types.

    Why do you think fathers and mothers (can-) have a good influence on their adolescent kids?! Because they think medium- to long-term welfare of the kids themselves, not their own pocketbook, not their own vacation, not their ego, just “the sustainability of the kids in turbulent times”(then again, haven’t ALL times been turbulent one way or another?). Put short-term thinking crooks and eager-beaver adolescents in one room and you’ve got an assured recipe for capital-destruction brewing.

    The brokers and FB management clearly didn’t understand that “you don’t become a widow’s and orphans’ share by wiping out your investors”. A reputation comes on foot and goes by hoof.

    OK, that said, the markets have opened up for buying puts on FB. “BUY and ACCUMULATE PUTS with strike-prices anywhere South of $25 to $15″ and see the avalanche gain speed.

  3. chipfield says:

    The investment banker undoubtedly has a very clear obligation to his underwriting client. What is less clear, but worthy of consideration, is the obligation (or absence thereof) that the underwriting firm also has to its retail clients to whom it sells the stuff. The interests of the seller and the buyer are often divergent, particularly with underwritings that are secondary rather than treasury offerings.

  4. Centurion 9.41 says:

    So very true an over simplification.

    However a fiduciary responsibility, THE primary one, to the shareholders of the firm bringing the IPO to market seems to be completely left out of the discussions on FlopBook’s success/failure.

    Seems to me that, again, IBankers, and almost all who tread upon the hallowed ground of moral/fiduciary responsibility ignore the primary responsibility to the underwriting shareholders.

    Since reputation, moral and fiduciary, are THE most important “equity” of all things financial, how is this subject so easily passed over without comment? The ignoring of this responsibility has played a central role in almost every financial crisis in which WallStreet/Bankers have played a central role. Likewise on the political side.

    Though the other points regarding fiduciary/moral responsibility are true, they are merely details of execution to the primary moral/fiduciary responsibilities. And if they had been held in their rightful place, I doubt much of this would have happened and people would be talking about how well FB held up during the past few days…

  5. cynical says:

    >>Alas, we don’t know if such counsel was ever shared with the management team, but we do know that it (or anything like it) was not taken.

    Right – you figured it out in 30 seconds and the bankers have their collective thumbs jammed where the sun dont shine. You have to start with an assumption that FB and the bankers are logical people. The banker who won the deal said what FB wanted to hear. And FB undoubtedly got what it wanted.

    To point 1/2 – If the market is opaque I can say that the valuation is depressed not over-inflated? It fits your theme but isnt necessarily logical. Those buys are most likely very large and sophisticated investors not some mom/pop hitting a buy button. Sadly no one can blame HFT or that would make for a nice scapegoat here.

    To point 3 – Long-term?? What is the average tenure of PMs? Or hedge fund investors? Come on for every Peter Lynch/Warren Buffet there at thousands of joe c-u-later asset managers.

  6. Bob is still unemployed   says:

    > just like most of its users average age . . .

    Some Facebook demographics:

    people 45 and older make up 46% of Facebook users.

    people 25 and older make up 86% of Facebook users.

  7. ConscienceofaConservative says:

    I have to agree with John Hempton on this. If I go to an investment banker, I want him to mazimize my price. Where I do see an issue is if there was selective dislocsure here, which is s real problem. What needs to get discussed more, is the attitude, or more correctly a sense of entitlent , amongst the retail public of a right to make money at the IPO. There were enoug warning signs between the made up metrics, the GM story, the dark pool of investors who got in early and the dual class structure that goes to governance, to suggest that many promoting and buying this were a little too Polyanna.

  8. Wez says:

    You’re leaving out the supply demand factor in Facebooks offering. Facebook came public at a ridiculous valuation because there was demand for the shares. Many IPOs are pulled and brought out at lower prices because no one wanted to buy the shares at the previously high offering price.

    The fact that the stock has gone down since it’s offering proves nothing (market is down too). Facebook has billions in revenue now and it’s free. What is their revenue and subsequent valuation if they figure out a way to get a billion people to pay for the service? I’m 44 and use Facebook constantly as do most of my friends. If they figured out a way to add some more value and wanted to charge for it, I would definitely consider paying a modest monthly fee. Many wouldn’t I know, but again we’re dealing in speculation here.

    The investment banks did a great job for their client Facebook. Amazon was considered a failed IPO at first, but because it is a real company with a sound business, it went on to do great in the market over time, just as Facebook can do. Pretending the investment banks should have some how predicted the future and offered the stock at a lower valuation is just silly. They offered it at the price the market demanded.

    BR: the share price reflects that the demand was not what they anticipated!

  9. Non Sequor says:

    I think in this case the mess was that Zuckerburg didn’t want to go public in the first place because it might undermine his control of the company. Then it became clear that some people were so eager to get in on this investment that they were ignoring the governance and valuation and so he could get away with an IPO that would raise banana town crazy pants money without any credible offer of value or responsibility to shareholders.

    You have a very clever but rather cavalier and reckless man child at the head of this company and a crowd of investors shouting this:

    How do you ethically negotiate a deal between two parties who are, if not irrational, at least can be said to have a mental blind spot about the important aspects of the deal?

  10. willid3 says:

    while i suspect many would question having ethics and Ibanker in the same sentence (unless its IBANKER sentenced for Ethics violations). but then I suppose its a different point of view when you look at it from the company going public. but then from the public’s perspective. they have trashed not just the companies reputation. but the markets too. as in the court of public opinion, they have convinced them that there is no ethics on wall street at all. now the real question becomes, does the public then consider it no better than going to vegas and gambling? or does repeat what they did back in the 1930s. where the avoided wall street like it was the black plague? and understand once convicted by that court, there are no appeals, and you can’t get your handy dandy congress person to change the rules. and the penalty can run for decades before there is any chance of a change.

  11. advsys says:

    Small technical point related to your third item. I don’t believe they wanted to go public. They had to. Some obscure SEC rule related to the number of employees with options. Not my area of expertise but I live in Silicon Valley and that has been mentioned to me by some lawyers.

  12. DeDude says:

    The problem is that the main vision held by the boy who owns the company is him having money and power. Not uncommon for that age group, but very uncommon in multi-billion sized start ups.

  13. [...] In fact, issuing banks know they have both an implied ethical duty to their purchasing investors, as well as long-term financial incentives, to issue new securities at a compromise level that satisfies the issuer’s need for capital yet allows long-term investors to also earn a return on their capital.  As is quite nicely articulated here. [...]

  14. Wez says:

    “BR: the share price reflects that the demand was not what they anticipated!”

    It came public at $38 because of demand, what has happened since it hit the market is meaningless. Institutions and individuals selling the shares after the IPO has nothing to do with what price it was offered at IPO. I work in the industry and nearly everyone was asking to get in. It is that initial demand that drove the offering price.

    Stop pretending that investment banks and Facebook should have, despite endless indications of interest for the shares, lowered the offering price as a sign of goodwill, that’s not how capitalism works my friends.

  15. [...] In fact, issuing banks know they have both an implied ethical duty to their purchasing investors, as well as long-term financial incentives, to issue new securities at a compromise level that satisfies the issuer’s need for capital yet allows long-term investors to also earn a return on their capital.  As is quite nicely articulated here. [...]

  16. Wez says:

    “to issue new securities at a compromise level that satisfies the issuer’s need for capital yet allows long-term investors to also earn a return on their capital. ”

    Nice sound byte, doesn’t work in reality. Pricing an IPO at a level that allows long term investors a return on their capital is unknowable. That statement implies knowledge of future events and outcomes. What determines a long term investors ability to earn a return on their capital is Facebook’s ability to continue to drive revenue and profitability over the long term, just like every other company you might invest in.

    Again, the shares were priced at the IPO based on endless indications of interest….demand. No one was forced to buy the shares at the IPO. If you feel it was overpriced, you didn’t hit the buy button….many people did hit the buy button though.