Facebook: An IPO Explainer
Facebook founder and CEO Mark Zuckerberg speaks during an event in San Francisco, Calif. The company is expected to announce an IPO soon.
Facebook is expected to file for an IPO today, probably after the market closes. We at Marketplace have been thinking about it from all the angles, and you'll see more of our coverage over the next few days.
But first, maybe it would help to cleanse your palate with an explainer.
This morning, listeners of Marketplace Morning Report (and, really, if you’re not, you’re missing out on one of the great radio shows of our time) heard me talking to our host, Jeremy Hobson, about why Facebook needs to hire investment banks to help the company go public. As I told Jeremy, going public just means that Facebook is selling its stock to the public for the first time: it's easy to understand if you break down the terms. An IPO is an initial (first) public offering (stock sale to the public.)
But what does that mean? Read on.
Why would a company go public?
There are four main reasons a company would file for an IPO. Here they are:
- Respect. Being a public company shows that you can swing with the big boys: you can make your quarterly earnings, maintain relationships with public shareholders, and are strong enough to stand up to whatever modern capitalism throws at you.
- To have a way to buy other companies. Another reason to become a public company is that having those shares listed on the NYSE or Nasdaq gives a company what Wall Street calls “a public currency." Those public shares are like money. So if Facebook wants to buy another company, it’s usually easier to buy the other company using Facebook’s publicly-listed shares rather than the alternative: laying out billions of dollars in cash.
- To let insiders cash out. In a private company like Facebook, it's relatively hard for people who have worked at the company for a long time to sell any of their stock. Once the company is public, those insiders can find a wide universe of buyers for their stock, cash it in, and start squirreling away more actual cash.
- To raise money to help the company grow. The actual cash haul from an IPO is generally small relative to a company's size. Most companies won't raise more than 20% of the whole value of the company in an IPO. Especially for a company of Facebook's size. (The company is rumored to be worth as much as $100 billion). A lot of companies like to use the money from their IPO for what they call "general corporate purposes."
Why does Facebook need to hire banks to go public?
So, let’s say Facebook has set its eye on raising $5 billion to $10 billion by selling its stock in the IPO. That’s an enormous amount of shares to sell - probably many millions of shares - and they need thousands of people to buy them.
Where would Facebook find those people? Facebook is busy trying to figure out how to make money from online ads and working on ways to broadcast your political opinions in Times Square. Facebook doesn’t know who’s out there buying stock in the market.
But investment banks do. Investment banks spend all day selling stock to people, so they have really good Rolodexes full of pension funds, mutual funds, rich individuals – everyone who’s going to buy giant chunks of stock.
Why would Facebook hire one bank instead of another?
Every bank has a different kind of Rolodex. Bank of America Merrill Lynch and Morgan Stanley, for instance, are well known for their ability to reach what Wall Street calls “retail” investors – that's Mom and Pop, Uncle Jane and Joe, you and me. They reach us through Merrill Lynch offices and Dean Witter brokerages. We’re called “retail” investors for the same reason that the clothes we buy are sold in “retail” stores – we’re likely to buy only a few shares at a time.
Banks like Goldman Sachs, Barclays Capital and Deutsche Bank, on the other hand, like to say they are known for their Rolodexes of “wholesale” or “institutional” investors – the big money managers, pension funds, and university endowments. These are well-funded institutions that are big enough to buy stock “wholesale” – in enormous chunks.
What do these banks do?
For a big IPO, you will have one to three banks leading the whole process. The lead banks have several jobs:
- To evaluate all of Facebook’s assets and help Facebook figure out how much it’s worth. This is called the company’s “valuation.”
- To evaluate what kind of risks Facebook’s business model presents to investors. More importantly, the banks have to make sure the company mentions those in the public documents.
- To line up a series of appointments with money managers, which is called a “road show.” On the road show, Facebook’s investment bankers talk face-to-face with groups of money managers, pitching them on the company’s strengths and its business prospects. At the end of the road show, the banks ask the money managers how much they would be willing to pay for Facebook’s stock. With big companies, banks like to put on a flashy road show. For instance, when Kraft Foods went public in 2001, all the participants in the road show received goody bags full of Oreo cookies, macaroni and cheese, and other processed delicacies. Facebook might not have goody bags - but most money managers would be happy just to shake hands with Facebook CEO Mark Zuckerberg, who's a folk hero to many capitalists.
- To figure out what Facebook shares should sell for. After the roadshow, the lead bankers get together and figure out what kind of share price will attract the most buyers while also raising as much money as possible for the company.
- To pick the best buyers for the stock. Bankers often get inundated with requests from money managers and good clients clamoring to get in on a hot IPO. It’s part of the bank’s job to make sure that it’s not selling shares to people who will immediately flip them for a profit. Companies like investors who are going to buy and hold.
- To provide research support for the company. Bankers and research analysts are supposed to stay on opposite sides of the so-called “Chinese wall,” which prevents conflicts. But a bank’s research analysts – and the promise of their subsequent coverage – are still a factor in why companies pick certain banks to lead their IPOs.
How many banks does Facebook need?
Quite a few. Think about it this way: The more people buy the stock, the more money Facebook can raise. So Facebook has no reason to pick one bank or two. It has up to $10 billion of stock to sell. So it will pick a whole bunch of banks with good connections. Those banks agree to “underwrite” the IPO: they buy all the available shares from the company. That means the banks will now take on the risk if no one else wants to buy those shares.
The banks then have to turn around and sell all the shares they’re underwriting to real investors who want to own Facebook stock.
Why would banks compete for an IPO?
Banks are eager to do this kind of work for two reasons: the rich fees, and the bragging rights.
Let’s start with the fees. For a long time, banks charged 7% for the work of underwriting IPOs. On big IPOs, those fees are a smaller percentage, but they’re still pretty considerable in real money terms. For instance, Kraft Foods went public in 2001, raising $8.7 billion. Though it paid its banks a 2.2% fee, that meant $190 million for the banks – a big payday. Even though Wall Street deals in billions and trillions of dollars, it’s not easy to rack up $190 million on a single deal – especially on something like an IPO, which is not a difficult task. Banks take companies public all the time, are pretty good at it, and can do it easily.
However, there’s a twist: an IPO fee is negotiated, so it’s a pretty good reflection of who holds the power: is it the company, or the banks? Facebook is rumored to be paying its banks a paltry 1% fee. That's very small on a $5 billion IPO. If that rumor is true, it means that Facebook has been able to cow the banks into taking less money.
For the explanation of bragging rights, keep reading.
Why would the banks take less money? Are they bad negotiators?
Maybe, but it’s more likely that they are measuring the benefit differently. Investment bankers often maintain relationships with companies for five, 10 or 20 years or more. They want to make sure they get future business as well.
So a savvy investment banker may say to his colleagues and bosses, “let’s take the smaller fee now, because if we take Facebook public we’re going to establish a good relationship with the company, and know a lot about how it works. So if Facebook does a merger later on, or sells more stock, we’ll be in a better position to help it in the future – and collect more fees over time. Besides, we don’t want Facebook to give any of its business to our competitors, so we have to be part of this IPO or hear about it from Rival X for the next 10 years.”
Don’t the investment banks have any leverage to negotiate with big companies like Facebook?
Investment bankers are known for their high self-esteem, but they can sometimes sell themselves short. Let’s look at Facebook again: Facebook is rumored to have picked Morgan Stanley to lead its IPO, with JP Morgan, Goldman Sachs, Barclays Capital and Bank of America Merrill Lynch in support positions. Those names should sound familiar: they’re basically the only big banks in the U.S. left that can shepherd an IPO of this size. Facebook may be the only game in town right now, but so are these banks.
You mentioned bragging rights. Twice already. What gives?
The bragging rights to a big IPO are also really important. To get an idea of why banks want to be part of a hot IPO like Facebook’s, picture this: It’s as if you were a teenager in the 70s and you missed the Rolling Stones concert that hit your town – or, in the 80s, Duran Duran, or in the 90s, Pearl Jam. Those bands didn’t perform all the time. You’d have to make an effort to be part of the action, right, to show that you’re cool and on top of things?
It’s the same with banks. They want to prove to all the other banks – and to potential clients – that they’re getting all the good deals on Wall Street. So bankers engage in all-out combat – or at least, as much as possible without mussing their suits – to be picked not just as any old underwriters, but as the lead underwriter. As the lead underwriter, they get to have the closest relationship with the company, do most of the work, get most of the glory, and - maybe best of all - boss the other banks around.
If banks don't manage to be at least an underwriter on a big IPO like this, they can expect heaps of scorn and disparagement from their fellow bankers.
But there could be, like, 10 banks on this big IPO. How do I know which one gets the bragging rights?
If you picture the cover of an IPO prospectus as a book report, you can read the hierarchy of banks through the formatting.
The lead bank – which is getting the most fees - has its name on the upper left-hand side of the page.
Sometimes, in big IPOs, there will be two or three banks acting as co-lead underwriters. That's because there's so much work to do, and because companies want to have as many banking relationships as possible, to make sure one bank doesn't get too big for its britches. In that case, the names of all three names will march along the page in a single line from left to right, evenly spaced. They will still, however, have incredibly petty fights over whose name gets the top left-hand side, even when they're all supposed to be equal.
Then there will be a single-spaced list of banks below them, in smaller print, near the bottom of the page: those are just the underwriters. Their only job is to sell the stock, and they don’t tend to have much of a role at roadshows. They mostly take orders from the lead underwriter.
What are the banks doing for all this time? How long does it take a company to go public?
Once a company files its prospectus with the Securities and Exchange Commission, it usually takes anywhere from two months to a year or more to actually get to the market, depending on market conditions and the SEC's reaction to the filing. Not only does a company have to take months to do that roadshow, but the SEC tends to scrutinize the prospectus very carefully and come back with questions. The company can’t go public until the SEC is satisfied that it’s telling the truth about its business.
Wait. You're calling it an initial public offering - but I'm a member of the public and I have no chance to buy this thing, right?
Probably. We use the word "public" here very loosely - it really means just some of the public. Your mutual fund can buy shares. But if you want to slap down your own cash, it's much harder. Unless you have an account with one of the underwriters - like, say, Merrill Lynch or Dean Witter - and you're a really good client with many, many thousands of dollars and a high appetite for risk, you are unlikely to get an offer to buy Facebook at its IPO price.
So, if you really, really want to own shares of Facebook, you'll have to buy them after they're listed on the public market. But watch out: for the first days and weeks after a hot IPO, that stock tends to get really inflated by all the excitement. So you would probably end up paying a lot more.
This random prospectus I’m reading says that a company wants to raise only $100 million, but everyone’s talking about this being a $20 billion IPO, for example. Should I blame the media? What’s the story there?
The first prospectus that a company files, with the help of its lawyers and banks, tends to be very cautious. Because the SEC scrutinizes the filings so carefully, companies try to leave financial details out of the first, second or even third drafts of its prospectus. The company has to say it will raise something, so for big IPOs, they’ll pick $10 million, $50 million or even $100 million as a “placeholder” number.
What’s the big deal about this prospectus, anyway? What does it tell us?
A prospectus is one of the richest troves of information about a company that you could hope for. Companies that have been private for years – like Facebook – have to disclose everything from their business history to their financial statements to a list of every single thing they think could go wrong with their company. They talk about their legal entanglements, their founders, how much their executives get paid, the fees they’re paying their banks, and other wonderful bits of information that help investors – and, ahem, reporters – understand a company much better.
I’ve kind of had it with hearing about this IPO. How can I stop the deluge?
Sorry. You could try moving to a moon colony.