Facebook's (FB) much-panned pricing of its IPO last May — at a price far above the range where the stock has since traded — might have been based in part on a private stock trade that was never completed, Facebook letters to the SEC reveal.
In the letters, company CFO David Ebersman sought the SEC's OK to include and exclude a number of private-exchange stock trades in calculating the initial public offering price.
Securities and Exchange Commission accountants allowed Facebook to give more weight to some transactions. SEC staff said the social networking leader should include all transactions that "are not determined to be disorderly," according to the letters.
This look into the murky IPO-pricing process comes from four letters Ebersman sent to the SEC, as Facebook worked to come up with an initial share price. Investor's Business Daily acquired copies, after a nine-month wait, through a Freedom of Information Act request filed with the SEC.
The offering eventually priced at $38. The stock closed Friday at 27.39.
The letters show Ebersman making some points that would seem to raise the IPO price — such as including that never-consummated trade — but making other points that would seem to lower the price — such as noting some investors wanted early Facebook shares as a "trophy.
However the calculations were made, the chief financial officer and the rest of Facebook's team are widely seen as having over-priced what became one of the most criticized IPOs ever.
The four letters show Facebook considered many of the prices paid pre-IPO on the private exchanges to be less than scientific. Still, private-exchange trades were one of the main factors that informed the $38 IPO share price, Facebook says in regulatory filings.
Confidential pre-IPO conversations are rarely made public, and it's unclear how often firms ask to include or exclude certain private trades, says Richard Puntillo, a University of San Francisco finance professor who's been an expert witness in shareholder suits.
"Everybody pushes the limit," Puntillo said. "You kind of look where the gray lines are, and there are times when you're not sure which side of the lines you're on, so you look for clarification.
Facebook declined to comment for this story.
It should be noted the private-trades subject of these letters do not play a role in the pending shareholder class-action lawsuit against Facebook, certain top executives (including Ebersman) and lead IPO underwriters. That case charges that Facebook selectively gave nonpublic information to certain institutional shareholders, shortly before the IPO, indicating Facebook would have trouble meeting its near-term financial projections because its users were moving to mobile devices faster than expected, and Facebook wasn't yet prepared to deliver many mobile ads.
Nor does this issue affect the technical troubles the Nasdaq suffered with Facebook's IPO that delayed trading and led Wall Street brokerages to claim multimillion-dollar losses. Nasdaq has offered $60 million in compensation but more legal action is possible.
As for the four letters — dated December 2011 to February 2012 — the one about including a trade that never happened "seems crazy," J. Edward Ketz, an associate accounting professor at Penn State University, told IBD. In the interest of objectivity, Ketz and Puntillo weren't told Facebook was the company in question.
"I cannot see how a firm would have any foundation" for using such a value, Ketz said.
The letters are signed by Ebersman, and cc'd are law firm Fenwick & West and auditors Ernst & Young, which advised Facebook.
In a Dec. 9, 2011, letter, Ebersman asked the SEC if Facebook could exclude what it deemed less-than-knowledgeable transactions in determining value, as "we believe that most private stock sales transactions that we historically observed do not represent fair value," Ebersman wrote. "As such, private stock transactions are generally not the sole or primary basis we used for measuring the fair value of our common stock.
Mostly Big Investors
By their nature, however, private exchanges tend to attract more pros than amateurs. Data are harder to find on private companies, and regulations are more lax.
SecondMarket, one of the largest private exchanges, says just 14.8% of the total dollar volume of its Facebook pre-IPO trades were to individuals. The rest of the buyers, it says, were hedge funds, asset management firms, mutual funds and venture capital firms.
Still, says one letter: "In many instances, the parties involved in these transactions would not be considered to be knowledgeable market participants.
The nontrade was among four transactions Ebersman detailed in the letters and that Facebook considered "relevant" in calculating its share price. It involved an "extremely high-net-worth individual who is a prominent businessman in India" who had planned to buy about 13 million shares in June 2011 at $32 a share. That sale didn't go through as expected the next quarter, and the buyer backed out altogether after broad stock market declines in early August 2011, according to the letter.
Still, Facebook "expressly incorporated" that into calculations of share value for the quarter, Ebersman says.
"The purchaser was deemed to be highly sophisticated," he wrote to the SEC, "and had the opportunity to perform financial and business due diligence and to meet with and asks (sic) questions of the company's management.
At the time, Facebook's "fair" value was $30.03, says the letter.
SEC responses aren't in the letters, although Ebersman rehashes some of what the agency said.
The SEC said it would not release its responses. SEC staff names on those letters "could subject the employees named in the correspondence to harassment," SEC FOIA Branch Chief Jeffery Ovall wrote in a letter to IBD.
Exclude 'Disorderly' Trades
But Ebersman's letters also show that SEC officials had told Facebook it should "incorporate all private stock sale transactions" that weren't considered in some way "disorderly." The SEC also told Facebook the "amount of weighting to place on each private stock sale transaction is a matter of judgment" for Facebook. After the final letter, Facebook added to its IPO regulatory filings that the quarterly average prices it presented were based in part on transactions that "were expected to be consummated.
Shares of Facebook were especially active in private-exchange trading because Facebook delayed its IPO longer than many expected, and many Facebook employees and early investors were looking for some liquidity.
Facebook to an extent encouraged such trades. SecondMarket says 86.4% of its Facebook share sales were from former Facebook employees, and another 1.4% were from existing employees.
Ebersman made the point that many private trades didn't represent Facebook's actual value at the time. Such a point can be "fair criticism" of private exchanges that don't share information, says SecondMarket CEO Barry Silbert, who wasn't asked specifically about Facebook.
Trades on private markets create data points that help inform an eventual IPO price, but they're not the only factor, he says. "It doesn't necessarily mean the price is too high or too low, but just that the price is not representative of the value," Silbert told IBD.
In one letter, Ebersman says Facebook's stock was a "trophy" to some investors, perhaps indicating people might pay more for the stock than they would otherwise.
Ebersman wrote that several "special purpose" funds had started buying Facebook stock on the private exchanges. And "these funds are often willing to pay higher prices than other buyers ... though they may have little or no access to any information about the company in question.
That's true, says Francis Gaskins, who analyzes public offerings at IPO Desktop.
"People get overly enthusiastic," Gaskins said, "they get caught up in the Silicon Valley wave of enthusiasm for tech stocks.
Many factors determine any IPO price, he says. Private-exchange trades are a factor but not the most important, he says, compared with calculations by underwriters and company executives with full access to a company's financials and user metrics.
Pre-IPO private-exchange stock prices ... might not represent what the public is willing to pay, Gaskins says.
Facebook shares were traded on private exchanges at least as early as April 2008, when they traded on SecondMarket for $3.50, according to the exchange.
The exchange SharesPost has said it logged hundreds of millions of dollars in pre-IPO Facebook transactions.
Facebook ended up pricing at $38 per share on May 17. On May 15, Facebook amended its IPO filing to raise its expected IPO range to $34-$38 per share from $29-$34.
But on private exchanges, shares of Facebook had been heating up since June 2011, when the businessman from India mulled buying 13 million shares for $32 apiece. January-April 2012, the average price traded on SecondMarket jumped nearly 35%, says the exchange. SecondMarket says its trading average for Facebook shares in April 2012 was 42.72.
Facebook shares briefly rose as high as 45 in the stock's May 18 Nasdaq debut before closing at 38.23 .
The stock hasn't gotten a sniff of 38, much less 45, since then. Shares hit a low of 17.55 on Sept. 4.
IPO Desktop's Gaskins says behind-the-scenes negotiations always take place. An IPO, he said, "couldn't happen without that confidential stuff that we don't see."