The degree to which Facebook (FB) exercised control over its IPO and strong-armed its underwriters to control its valuation is unsettling. Not only did Facebook take it upon itself to craft its own prospectus, but Facebook's Chief Financial Officer David Ebersman is reported to have told some bankers that he was skeptical over what value banks could make to a Facebook IPO. Apparently Mr. Ebersman didn't see anything wrong with the fox watching the hen house.
Potentially the biggest issue surrounding the Facebook IPO is that Facebook based its valuation on implied valuations which were set in thinly traded secondary markets such as SecondMarket and SharesPost. According to its prospectus, the valuation was determined by relying on "recent private stock sale transactions" between periods Q1-2011 and Q1-2012. In fact, Facebook was so confident that it assigned the implied valuations a 50% weighting in their "fair-market" valuation "due to the significant volume of third-party private sale transactions."
Conveniently, as the implied share price on the secondary markets rose to a high of $45 before the IPO, Facebook followed suit and made several aggressive upgrades to its valuation. The May 17 prospectus reported that the first revision to the valuation was "influenced by third-party private stock sale activity that occurred in January 2012," and in the second revision just days before the IPO Facebook raised its anticipated IPO price from $25 - $35/share to $34 - $38/share "on the assumption that our limited public offering had occurred and that a public market for our Class A common stock had been created and therefore excluded any marketability or liquidity discount."
This assumption was reckless for three reasons. First, the float from third-party transactions was clearly insufficient to assume public market liquidity, especially when Facebook intended to dump $16 billion in stock on the market at the IPO. In fact, since Facebook started trading on SecondMarket in 2008 up to the IPO, it traded less than one trade every two days, and there were fewer still on SharesPost. In comparison, an average company on the NASDAQ trades over 3,000 times per day. Second, secondary markets are asymmetric. Most sellers were either Facebook insiders or early-stage investors whereas most buyers were optimistic institutional investors. Third, market participants were not a representative sample of public market participants. Fourth, liquid markets do not jump discontinuously, adding billions of dollars to a valuation, from a single $4 million transaction.
While there is no evidence of stock manipulation in the secondary markets leading up to the Facebook IPO, the secondary markets are ripe for abuse because illiquid, thinly traded stocks can be easily manipulated in so-called "pump-and-dump" schemes which often plague OTC markets and the micro-cap venture exchanges.
Nevertheless, Neil Rothstein, an attorney at Kahn, Swick & Foti, who is working on the Facebook lawsuit noted, "Facebook and the other defendants will have a more significant hurdle to jump in the courts since the plaintiffs need not prove fraud, only negligence pursuant to the applicable securities laws." Rothstein added, "The standard of proof for negligence need only show that untrue material facts were made in the Registration Statement and Prospectus. There are other allegations of material negligence regarding the Facebook IPO as well."
Facebook had no business ignoring its underwriters and opening at its lofty IPO valuation, and it was reckless to assign so much weight to illiquid market activity of investors who were not a representative sample of the market. However, to be sure there was no funny business, Facebook needs to open its books and we need to demand that the SEC investigate these transactions to ensure that there was no stock-manipulation in the private and secondary markets.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.