Facebook’s Fickle Friends

In the build-up to Facebook’s (NASDAQ: FB) initial public offering (IPO) on May 18, the social media giant was valued at a staggering $100 billion. Many analysts were predicting that the event would be the greatest, most successful IPO of all time. What a difference three months makes.

Where are Facebook’s “friends” now? Today, the occasion is viewed as perhaps the worst IPO failure ever, with possibly more downside to come.

Facebook closed trading on Thursday, August 16 at 19.87, down 6 percent. It was the first day on which employees and early investors were allowed to sell the millions of shares they hold; the stock hit an intraday low of 19.69.

After the IPO on May 18, priced at 38, the stock traded as high as 45, with shares closing the day at 38.23. A colossal trading systems screw-up kept traders in the dark for up to 90 minutes after the opening, leaving them unsure as to whether their trades had cleared. This unprecedented failure of market operations, combined with the consensus that the IPO was grossly overprice, pushed the price off a cliff.

The closing price was maintained above 38 on the first day of trading only because of a massive infusion of buy orders from the IPO underwriters, noted at the time in my May 21 Investing Daily article, What Really Happened with Facebook’s IPO. Two days later, the shares closed at 31. Twelve days later, Facebook traded as low as 25.52. However, the stock briefly turned around and things started to look up. For a couple of days near the end of June, Facebook saw intraday highs above 33.

With the close below 20 yesterday (August 16), the decline within three months of the IPO has been approximately 48 percent from the IPO price (38) and has reached just short of 56 percent from the first day’s intraday high (45).

The Lock-Up Expires; Hell Breaks Loose

The reason for the decline by more than 6 percent on August 16: the expiration this week of the insider lock-up period for 271 million shares of restricted stock.

Restricted stock is comprised of shares held by insiders such as early venture capital investors and company employees. This makes 271 million additional Facebook shares available on the market and has two potential effects:

1. The price could be further depressed if a significant number of these new shares are offered for sale.

2. The price could be pushed higher if the greater number of shares eligible for hypothecation allow short interest to rise significantly (more shares available to borrow for shorting) and the insiders (and others) do not offer shares for sale.

Why could the second scenario boost the price? The reason is called a short squeeze, as explained below.

While the direction of the market on August 16 appeared to favor the first possibility, the second could come into play in the coming days. The volume of trading on August 16 (157.6 million shares) was more than 3.4 times the average daily trading volume.

If a significant portion of this increased number was from short sales rather than normal sales, and if the newly released shares are not offered in appreciable numbers in the next few days, it would not take considerable buying to create a major short squeeze. In that case, Facebook could see a quick price spike back into the mid-20s, where it was trading just over two weeks ago at the end of July.

The outcome of the current restricted stock is just the first chapter of what is to come. Many more restricted shares will be released in the coming months:

  • 243 million shares between October 23 and November 13
  • 1.2 billion shares on November 14
  • 149 million shares on December 14
  • 47 million shares on May 2013
Consequently, the August 16 exercise in restriction removal represents only about 14 percent of all the restricted stock that will be available to the market within months. The market outcome of the current absorption process for released restricted shares is unlikely to provide an exact template for what will happen in the future, especially in October when the shares will come primarily from Facebook employees and in November when the release will be nearly 4 times the one on August 16.

Before the IPO, some clear-eyed analysts stated that Facebook’s shares were overvalued in the 30s and the real value of the stock was below 20. In his May 17 article, Unfriending Facebook, immediately before the IPO, contributing editor Andrew Butter valued the stock at 11. What seemed unduly pessimistic at the time now appears rather prescient.

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John Lounsbury is managing editor and co-founder of Econintersect LLC, publisher of Global Economic Intersection, a web site that focuses on the economic aspects of finance, investing, social interactions, and politics/public policy.