Facebook aims to avoid Zynga woes

With a breathtaking 845m users a month and an arguably unprecedented level of hype, many are already touting Facebook’s forthcoming US$5bn–$10bn offering as a sure-fire winner.

But structural changes in the IPO market may mean a higher degree of difficulty than widely thought for the Morgan Stanley-led underwriting syndicate behind the ubiquitous social networking site’s new issue.

As with social gaming company Zynga’s disappointing US$1bn IPO in December, one issue that could test the syndicate is the extent to which large and influential institutional investors already have significant exposure to Facebook, as a result of earlier private funding rounds and reflecting the pre-IPO stock trading that has become a more active feature of the market in recent times.

If key institutions already have big holdings of Facebook stock prior to the offering, the bookbuilding could encounter less demand and weaker pricing tension. That could leave more stock to fall into the hands of fickle short-term traders, reducing the chances of Facebook achieving a mooted US$100bn valuation and weighing on its aftermarket performance.

A lack of follow-through buying by long-only funds was one factor in Zynga’s slump below issue price on its debut – a situation that Facebook’s underwriters (Morgan Stanley also led Zynga’s IPO) will be eager to avoid.

Private trades

Banking sources say more of Facebook’s stock is held in the hands of institutional investors than is evident from the S-1 registration document filed with the SEC last week.

The S-1 lists T Rowe Price as a holder of 6.03m Class A shares and 12.16m Class B shares, but apart from holdings controlled by Goldman Sachs as part of its special private placement last year, it is the only institutional investor listed (Fidelity is another known institutional shareholder).

Despite complications and high transaction costs associated with buying private company stock, more Facebook stock is available than is suggested by trading statistics for private company stock exchanges such as SharesPost and SecondMarket, bankers say. For example, a prominent New York-based fixed income manager recently sought buyers for a US$1bn block of Facebook stock, according to one banking firm asked to bid on the block.

Several US$100m-plus blocks have also been discreetly touted around Wall Street, which is doing a growing and increasingly active trade on behalf of clients in private company stock.

If key institutions already have big holdings of Facebook stock prior to the offering, the bookbuilding could encounter less demand and weaker pricing tension

One way in which underwriters may seek to deal with the issue is to limit the size of the offering, to create more scarcity. This may be one reason why Facebook has opted initially to register for a conservative US$5bn offering, instead of filing for the US$10bn sizing that had been widely expected. If Facebook is ultimately valued at US$80bn–$90bn at the IPO, US$5bn would represent a free-float of only 5%–6%, whereas Zynga sold closer to 15% of its stock in its offering.

Crucial quarter

Still, some analysts argue that comparisons between the Zynga and Facebook IPOs are unfair, despite their overlapping interests (Zynga relies on Facebook for most of its revenue, while Facebook gets 12% of its revenue from Zynga).

Greencrest Capital analyst AB Mendez said Zynga had suffered from reporting a flat quarter just prior to the IPO. Facebook’s 2011 revenues of US$3.71bn as reported in the S-1 were slightly weaker than some expected, but it might be able to deliver a strong first-quarter performance to stir further investor excitement ahead of pricing the IPO.

University of Notre Dame finance professor Tim Loughran said he expected Facebook to get a “full” valuation, noting that the company’s high user base had removed much of the uncertainty usually faced by internet companies. But, he said, having Morgan Stanley as lead underwriter could be a negative factor. “It does not appear that some of the deals they have done have set the market on fire,” he said.

Facebook is using some of the proceeds from the offering to pay expected tax on employees’ restricted stock units, while co-founder Mark Zuckerberg is offloading some of his shares solely to pay a tax bill resulting from an upcoming options exercise.

“They are going to have a big tax bill for the employees six months down the road. Ideally they would do an equity deal closer to the time, but they are making sure they have flexibility,” said one banker close to the deal.