Facebook, One Year Later: What Really Happened in the Biggest IPO Flop Ever

After Facebook's disastrous debut, the preferred clients of big banks walked away with huge profits. How? Public documents and interviews with dozens of investment bankers and research analysts reveal that the Street caught wind of something the public didn't. The social network and the banks told half the story. Here is the other half.
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Reuters

Uma Swaminathan tuned the television set in the living room of her ranch style home in the suburbs of East Brunswick, N.J. to CNBC. It was 9:00 a.m. on May 18, 2012, a day the retired schoolteacher thought might make her rich. She logged onto her Vanguard brokerage account on her computer and placed an order for 5,000 shares of Facebook at $42 a share.

On TV, wearing his trademark hoodie, 28-year-old Mark Zuckerberg, creator of the world's largest social networking site, stood in the courtyard of Facebook headquarters in Menlo Park, California. A crowd of eager Facebook employees held up company license plates and posters for the cameras. They'd stayed up all night at an employee "hack-a-thon" to celebrate the big day when Facebook was finally going public, in what might have been the most anticipated initial public offering in history. The boyish, blue-eyed Zuckerberg grinned, standing next to Bob Greifeld, chief executive of Nasdaq-OMX Stock Market, Inc., the largest electronic stock exchange in the United States.

With short hair, brown skin, and few wrinkles, Swaminathan looks much younger than her 68 years. She spent most of adult life as a suburban mom, making tofu for her daughter's friends at theater rehearsals, taking her three sons to soccer practice and Boy Scouts, and volunteering in the local community. She served a term as president of the Indian American Association of New Jersey.

Her interest in the stock market didn't develop until her husband died about 13 years ago. Her four children had already moved out to attend college or to pursue their careers. Swaminathan was left with her late husband's 401(k) retirement account, when she started dabbling in the market, investing in stable companies like Microsoft. Not long after, she began to follow the news coverage of initial public offerings (IPOs) -- when private companies enter the public market -- and came to know of the phenomenon known as the first day "pop." On the day that companies would debut on the stock market, the price would tend to shoot up before stabilizing. A year earlier, she watched as social networking site LinkedIn's stock price closed up 109 percent on its opening day.

She'd never placed such a big bet on just one stock, but she felt a personal connection to Facebook. She had been using the site to connect with family and friends since 2009, and almost everyone she knew had an account.

Now, as she watched the TV in eager anticipation, millions of shares were going to leave the hands of private investors and start trading, giving anyone with enough money a chance to own a slice of the social network giant. Silence descended as Zuckerberg came forward to deliver his speech: "I just want to say a few things, and then we'll ring this bell and we'll get back to work. Right now this all seems like a big deal. Going public is an important milestone in our history. But here's the thing: our mission isn't to be a public company. Our mission is to make the world more open and connected..."

Finally he reached the moment so many were waiting for: "So let's do this!" And the opening bell sounded as he signed the digital screen on the podium before him: "To a more open and connected world," he wrote. His handwritten message instantaneously appeared in Times Square just above the giant illuminated NASDAQ exchange ticker.

Facebook shares hit the market at an opening price of $38. Minutes later, Swaminathan's online order was executed, and the retired schoolteacher had just spent approximately half her life savings.

Screen Shot 2013-05-20 at 8.19.03 AM.pngI: THE OFFERING

For Mark Zuckerberg, selling Facebook shares on the public market had a clear downside. Besides the headache of releasing a company's financial details to the public, he worried that increased scrutiny and push for profits would compromise Facebook's mission.

But like any growth-stage company, Facebook needed money, and private companies face restrictions on how much stock they can issue for cash. In early 2011, Goldman Sachs helped Facebook conjure IPO-type money without an actual IPO by creating a special investment product to sell its private shares to Goldman's wealthiest clients. But when the New York Times exposed the plan, the SEC began to investigate the transaction. Soon after, Zuckerberg decided to take the company public. In late 2011, the Wall Street Journal reported that Facebook was anticipating an IPO valuation of $100 billion -- nearly four times more than Google's market cap when it went public in 2004.

On February 1, 2012, Facebook filed its Form S-1 -- effectively a birth certificate for publicly traded companies -- containing everything an investor needs to know before buying shares at an IPO, including basic financial information and the business model. Facebook's S-1 showed that the company was primarily in the display-advertising business, with a net profit of $1 billion in 2011 from total revenue of $3.7 billion.

The S-1 is especially meaningful to investment banks. Facebook listed its underwriters -- the banks picked to buy and sell shares on the IPO -- near the front of the document, from left to right, in order of responsibility, with Morgan Stanley in the coveted "left lead" position.

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This put Facebook's IPO in the hands of one of Silicon Valley's most celebrated bankers: Michael Grimes, co-head of global technology banking at Morgan Stanley's Menlo Park office, located just a few miles north of Facebook's headquarters.

II: THE BANK

Michael Grimes, the son of a mapmaker, is a lifelong Californian with a bachelor's in computer engineering from UC Berkeley. A titan in the world of tech IPOs, his status grew not only from expertise in taking small and large digital companies public, but also from his myth-making showmanship. To win Ancestry.com's IPO, he created his own family tree and wore a green Hermes tie with leaves to signify the company logo. To get a Hewlett Packard acquisition, he waited outside an executive's office for hours just to make a pitch.

With Grimes and the investment bank prepping the offering and building demand for shares, it fell to another Morgan Stanley employee, Scott Devitt, to tell outside money managers whether they should buy Facebook stock. As the head of Morgan Stanley's Internet equity research team, Devitt makes a 12-month target price for stocks and provides a rating -- buy, hold, or sell -- for hedge funds like Citadel and large, storied institutional investors like Fidelity. Devitt's agreement with his clients guarantees an independent analysis of company performance -- even if Morgan Stanley is leading the IPO. (Devitt advised clients on whether to buy companies like LinkedIn, Zynga and Pandora while Grimes orchestrated their IPOs.)

The stark division between these two functions of a bank is known as a "Chinese Wall." It forbids investment bankers, like Grimes, from influencing research analysts, like Devitt. Morgan Stanley and other brokerage firms were slammed with fines for repeatedly breaching the "Wall" during the dot-com boom. In the aftermath of the Facebook IPO, the bank would find itself under the spotlight yet again for allegedly sharing key, private information with wealthy clients.

In Facebook's case, the trouble began with a simple revision.

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III: THE REVISION

A roadshow -- a city-by-city promotional tour where executives drum up support for their IPO before large investors -- is typically a lackluster affair. Facebook's was more like a Hollywood party.

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Khadeeja Safdar is writer based in New York. Her work has appeared in The Huffington Post, The Express Tribune magazine, and The Tampa Tribune.

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