Facebook's Initial Private Offering

As investors enjoy their second straight January with positive brokerage statements in the mail, there's more than a whiff of optimism in the air. The Dow Jones Industrial Average is on course for its biggest two-year bull run since 1932, and individual investors are finally showing signs of getting back into stocks. The period Dec. 1 to Dec. 29 saw a total of $14.90 billion move out of bond funds and $5.51 billion into stock funds.

The appetite for risk is back. For better or worse, people are ready to get in on the next hot play. America, after all, has always been a place where investors could ride the good fortunes of its most innovative companies. Hasn't it?

In 1995 the locus of innovation was Web pioneer Netscape Communications, whose initial public offering ignited five of the most lucrative years in market history. In 2004 it was Google (GOOG), whose "Dutch auction" IPO invited anyone to bid on a share price; those who bid over $85—small and large investors alike—got in on what has turned out to be a 618 percent return.

Today, the It company is Facebook, the seven-year-old social network that last summer bagged its 500 millionth active user and whose founder and chief executive officer, Mark Zuckerberg, was named Time's Person of the Year for 2010. When a privately held company displays this level of innovation and enjoys this level of success—when it captures the public imagination to such a remarkable degree—it's only natural that investors want to own a piece of it. Secondary exchanges such as SharesPost have been trading insiders' shares of Facebook at a level that values the enterprise at $42 billion. A Facebook IPO would benefit insiders and investors alike; all the 26-year-old Zuckerberg needs to do is reserve the ticker symbol—FACB? FRND?—and say the word, and the wealth-creating magic of democratic capitalism would unfold.

It isn't unfolding, however—at least for now. In what feels like a profoundly unfriendly move for a company with 500 million friends, Facebook has struck a private deal with Goldman Sachs (GS) and Russian investment firm Digital Sky Technologies (which is full of Goldman veterans) to sell them a $450 million and $50 million stake, respectively, in the company. A preferred and limited roster of Goldman clients would also buy in to the tune of about $1.5 billion. The deal, which values the social network at $50 billion, or more than two Yahoo! (YHOO)s, is expected to be structured by Goldman to allow Facebook to remain below the 500-investor threshold that would force it to make an array of Securities and Exchange Commission disclosures. A special Goldman fund with numerous client investors, the legal thinking goes, could be counted as a single investor.

Some funds within the wealth management division, such as the hedge fund Goldman Sachs Investment Partners, are also likely to get some of the private Facebook stock, according to two people familiar with the matter who requested anonymity because they weren't authorized to discuss the deal. Clients are being offered the opportunity to invest as much as $2 million apiece with Goldman taking a 4 percent placement fee and 5 percent of any investment profits plus an annual servicing fee, according to two clients who were offered shares. "If you're an underwriter, you love this kind of discretion," says Jay R. Ritter, a University of Florida professor who studies public offerings. "It gets you the maximum pay-to-play benefit."

The structure of the deal is also novel. While Goldman Sachs routinely distributes offerings to its institutional and high-net-worth brokerage clients (minimum account size: $10 million), interested buyers this time would have to agree to hold on to their shares until 2013 and keep a lid on material nonpublic information. Stephen Cohen, a Goldman Sachs spokesman, declined to comment.

Laurie Simon Hodrick, a professor of capital markets at Columbia Business School, sees the arrangement simply as another venture capital round for a company that would rather remain private for now. Goldman, she notes, was willing to provide capital on the terms Zuckerberg wanted. "If Facebook is a student of history," she says, "they'll remember not just Netscape's IPO but the cautionary tale of what happened afterward." (After ceding its dominance of the browser market to Microsoft (MSFT), Netscape sold itself off to AOL (AOL) in 1999.)

Even so, this deal is a long way from the ideals of democratic capitalism. If anything, it signals that when Zuckerberg finally does decide to take Facebook public, the IPO will see value and information accrue to connected insiders, while those 500 million friends are left scrambling for aftermarket odd lots. Factor in the hot public offerings that have been limited to big investors recently—General Motors (GM), Tesla Motors (TSLA)—and it's hard to argue that the resurgent IPO market, dormant for three years, is becoming more open.

It's a development that runs counter to the spirit, if not the letter, of the new financial regulations passed in the wake of the crisis. "The Facebook investment sends a message to institutional investors that Dodd-Frank and Basel III have not hobbled Goldman's business model and that the magic remains," says Brad Hintz, an analyst at Sanford C. Bernstein (AB). "From Goldman's point of view, this is a way of ensuring it wins the lead underwriting position when Facebook goes public." That would not only generate a windfall on Goldman's current investment but would also win fresh clients from Facebook's workforce and earn dibs on future IPOs from related plays like Zynga and Foursquare.

In truth, there has never been anything very public about the initial public offering. "The sad reality is that the only IPOs that the mom-and-pop investor have access to are the ones you don't want," says Rodd C. Langenhagen, a tech banker with Morgan Keegan. "Ironically, the more safeguards we build into the system to protect investors, the more companies don't want to go public, so investor access relies on even less regulated special purpose vehicles and secondary share markets. Just like drugs and alcohol, the more you regulate it, the more it's driven underground."

Brokerages that make their money by providing market access to small investors argue that the little guy is fully capable of giving issuers like Facebook the capital they need. "We want to provide a level playing field, equal access," says Paul Renken, vice-president of relationship management at E*Trade Financial (ETFC). "There's a disconnect on Wall Street IPOs between shareholders and customers." He is among those who say that GM, the recipient of a $50 billion taxpayer bailout, slighted retail investors in its record November IPO by declining to allocate to online brokers. Aftermarket shares were the most traded on E*Trade that day, a signal of unmet retail demand. "It could have been a great opportunity for all involved," he says.

Facebook could be, too. For all the social network's fierce independence and little-guy appeal, however, Zuckerberg is apparently not bothered by the kind of insider capitalism that marked the dot-com boom and bust, a period that saw more than 300 lawsuits and settlements linked to IPO allocation fraud and compromised Wall Street research. But Facebook's founder was in high school then, and that tempest is long forgotten.

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