Facebook: The shares shenanigans

Investors are crying foul over the huge losses they incurred when the social network site floated on the stock market last week. Stephen Foley reports on a financial fiasco

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The Independent Online

So, no honeymoon, then.A week ago, Mark Zuckerberg was celebrating his first morning as a married man, and a $19.1bn married man at that. The previous Friday, Facebook's founder had floated his social network on the stock market, with the eye-popping valuation of $104bn, making millionaires and billionaires out of his early staff. Then he had wed his Harvard University sweetheart Priscilla Chan in a romantic backyard ceremony that he had managed to keep totally secret despite months of planning – a feat that must be unique in the post-privacy era ushered in by Facebook.

How long ago they seem now, those cheers and high-fives at company headquarters, and those wedding-day smiles. One week later, and Mr Zuckerberg might be forgiven for thinking: what in the hell happened?

After seven days of unfolding fiasco, Facebook's newly minted shares have plunged 18 per cent, lopping Mr Zuckerberg's personal fortune down to $15.8bn and the value of the company to $86bn. The 28-year-old founder is the subject of at least eight lawsuits that allege the flotation was, in effect, a fraud on the investing public. More alarming, even than that, it is as if the scales have fallen from investors' eyes, and where they once (10 days ago) saw an internet juggernaut destined to rake in billions of dollars from advertisers, now they see a juggernaut already plunging into a ditch.

The market debut of Facebook "was predicted to be the most important market event in recent history, generating tremendous enthusiasm", according to one of the lawsuits naming Mr Zuckerberg, his fellow directors and his bankers. "What transpired, however, has proven to be an additional blemish on Wall Street's already damaged reputation and provided more evidence that investment banks and their clients are apt to favour hedge funds and other large clients over retail customers."

The suit, filed by the firm Wolf Haldenstein Adler Freeman & Herz in San Francisco, is one of a number representing small shareholders who bought in to the initial public offering (IPO) and who are now sitting on losses. The complaint they all have in common? The investment banks closest to Facebook secretly cut their predictions for how much the company will make from advertising this year, thanks to a tip-off from the company, and only a few favoured investors got to hear about it.

Ad revenues in the first three months of 2012 had already proved worse than expected; early indications were that the second quarter was off to a bad start. The downgrades, which appear to have been triggered by guidance from the company, were made by the banks about two weeks ago, just days before the flotation, but they were revealed publicly by the news agency Reuters only on Tuesday morning, triggering a new wave of selling in Facebook shares.

For many of the ordinary investors who had been clamouring to buy stock during the hype of the week before, the Reuters report was news two times over. Investment bank forecasts are not part of the share prospectus published by Facebook, the formal marketing document for the IPO. Many ordinary investors didn't know the forecasts existed, let alone that they had been cut just days before they put in top-dollar bids for the stock.

Large institutional investors did learn about the changed forecasts before the float thanks to phone calls from the banks themselves, among them Morgan Stanley and the other underwriters of the flotation. If these big investors' ardour for Facebook shares cooled as a result, it didn't matter because small investors – those out of the loop – were clamouring to get in. Some reports suggest as much as 25 per cent of the shares sold on flotation were ultimately sold to small investors.

"Facebook basically pre-announced disappointing second-quarter results, but this information was only shared with a handful of the investors who were considering investing in the IPO," said Henry Blodget, the dot.com-era tech analyst who was thrown out of the securities industry for hyping the prospects of new companies that, privately, he didn't believe in.

Mr Blodget emerged from the shadow of his disgrace last week to become one of the most scathing commentators on the Facebook flotation. "Regulators will now look into whether Facebook's public disclosures and the underwriters' behaviour broke any laws," he wrote. "But irrespective of legality, obviously, this selective disclosure of critical information was grossly unfair."

Facebook and Morgan Stanley, for their part, say they did nothing illegal. In fact, Morgan Stanley told its own disgruntled clients who had bought-in that they did the best they could to get the new information out, within the limits imposed on analysts' research after the Blodget scandal a decade ago. That may ultimately prove to be the conclusion of the Securities and Exchange Commission and the Financial Industry Regulatory Authority, which are investigating, and the Facebook debacle may lead to a change in the rules rather than massive fines on Facebook itself.

But whether or not the deterioration in Facebook's business outlook should have been more widely communicated, the thing that really spooked the markets is this: Facebook's business outlook has deteriorated. This is no small matter, since the $104bn valuation put on Facebook at the float was based not on the company's track record of revenues and profits – which is short and modest to date, with $1bn of profit on $3.7bn of revenues in 2011 – and based instead on investors' hopes for a quick increase in advertising income in coming years. Since its 900 million users are spending more and more time on Facebook, and sharing more and more information that advertisers can use to tailor their messages, it stands to reason, Facebook's cheerleaders say, that more and more advertisers will spend their money on Facebook ads in future instead of on traditional media, such as TV, radio or magazines.

That was certainly the message being pushed in the glitzy marketing video starring Mr Zuckerberg and fellow Facebook executives, which was made for prospective investors. In the video, the boss of Ben & Jerry's ice cream claimed the company made $3 in sales for every $1 it spent on Facebook, while American Express trumpeted how it had used Facebook ads to spread the word about its Small Business Saturday campaign.

But for investors who wanted to look through the optimistic claims, there have been warning signs aplenty this year. In retrospect, when Facebook put on a lavish conference for marketing executives in February in New York, the home of the American advertising industry, it was less a celebration of Facebook's power than it was a plea by the company, asking ad execs not to give up even if early results from paying for advertising on the site had been modest.

Carolyn Everson, Facebook's head of global marketing solutions, told The Independent on Sunday on the sidelines of the conference that "80 per cent of my job" is teaching advertisers how to create ads that users want to share. Nigel Morris, head of the ad agency Aegis, told attendees that "there is a role for paid media to make sure content gets into the hands of the right people", but it sounded as if he was more in favour of companies just putting up free Facebook pages and sending messages to their fans.

Nate Elliott, a researcher at Forrester, channelled some of the grumbling of the ad industry through a piece to his clients earlier this month, saying that: "Facebook still hasn't stumbled upon a model that's proven consistently successful for marketers." He added that instead of buying the photo-sharing app Instagram for $1bn this spring, Mr Zuckerberg ought to have spent the money on new ad technologies or marketing measurement tools – anything to help advertisers.

The final clue was General Motors, maker of Chevrolets and Cadillacs and the third-largest advertiser in the US, saying on the eve of the flotation that it would stop buying Facebook ads completely. It spends only $40m of its $1.8bn annual advertising budget on the social network, and only $10m of that on paid-for ads (the other $30m is spent on curating its Facebook page), but that $10m did not generate enough of a response to bother expanding the experiment.

Combine these straws in the wind with the revelations of the second-quarter downgrades and the fact that Facebook's users will increasingly spend time accessing the site on mobile devices, where ads are even fewer and further between, and you have that sense of an advertising juggernaut veering off towards the ditch.

This "sell" case on the shares came together too late to stop people buying in at a valuation of $104bn, but it has come together solidly now. The sense that investors were duped may last even longer than the regulatory investigations and legal battles to come. It was always going to take years for Facebook to generate the profits to justify that valuation; it seems there are fewer investors this week who are willing to stick with it to find out.

It is always hard when a honeymoon is over – harder still never to have had one.