The ink was barely dry on the press release announcing the recent sale of $1.5 billion in shares in Facebook to Goldman Sachs and overseas investors when conservative commentators argued the deal demonstrated the dangers of the regulation of our financial markets.
Jonathan Macey, a law professor at Yale and a fellow at the Hoover Institution, contended (perhaps unsurprisingly, on the opinion page of The Wall Street Journal) that Goldman’s reversal of its initial plan to include U.S. investors in the offering was a “fiasco” for the Securities and Exchange Commission (SEC). In essence, he suggested, we lived in an overregulated nanny state that is, in his words, “crippling for U.S. investors.”
But this argument misstates what happened and why. Instead of a “fiasco,” the rules that forced Goldman and Facebook to change the deal are precisely what make our capital markets the most attractive in the world. Last year there were 35 Chinese IPOs in the US, a record. Even Renren, China’s version of Facebook, is planning a U.S. IPO in 2011. Why? In part, because the securities laws here provide real value to investors and companies alike.
It is true that companies in places like China can now conduct very large equity offerings. This was, indeed, unheard of a decade ago. But our securities laws are not driving that process. Instead it is the global imbalance in savings, which have swung wildly in favor of China because China is now an export platform to the US, relying on its cheap non-union labor to generate huge cash flow that then finds its way into speculative capital markets.
For example, Sinovel, a wind power turbine manufacturing company tied to a top Chinese official went public last month on the Shanghai exchange raising more than $1.4 billion. But the stock price of the company crashed on its first day as a public company by nearly 10% from the IPO price!
As my research with Stanford-based economist Jennifer Kuan shows, this kind of collapse is basically unheard of on America’s carefully regulated and institutionalized stock exchanges.
Like many other startup companies in the Valley, Facebook needs capital to grow and expand. Eventually the company will be stable and profitable enough to support an offering of its shares to the wider investing public in an IPO. Until then, state and federal securities laws allow firms to avoid the time and expense of preparing a detailed prospectus by limiting stock sales to sophisticated investors, usually wealthy individuals or large institutions like venture capital funds that can afford the risk of investing in early stage companies.
Regulators like the SEC, however, remain vigilant about the possibility that a startup company, its investment bankers and its investors may have a vested interest in “pumping up” the positive side of the story about the company so that when push comes to shove, they can dump their shares on an unsuspecting wider public.
This appears to have been a potential problem in the Facebook offering. When news of the deal surfaced so did new information about the company, including reports that it was now worth $50 billion and that the site now has 600 million users worldwide. For a company formed in a college dormitory only a few years ago these are astonishing figures.
But hold on a minute. That’s the good news. Yet we know from long and sometimes painful experience here in Silicon Valley that today’s success is tomorrow’s bankrupt dot com. Because of the inherent risks in any new business venture, the securities laws require that firms, in addition to the good news, provide investors a detailed description of the risk factors they should take into account before they make an investment decision.
These factors might make clear that while Facebook has 600 million users it is likely uncertain how much revenue the company can generate from them or how long they are likely to remain members of the site. Until a detailed prospectus is made available we don’t know the answers to these questions. And notice, those risk factors protect the company, too. They act as a form of insurance if well written and informative. If investors ignore them it is much more difficult to sue a company if something goes wrong.
So it made sense for Goldman and Facebook, perhaps with the advice of the SEC, to rethink their attempt to sell more than a billion dollars of Facebook stock to U.S. investors without providing the more nuanced disclosure required in an IPO. Instead, the deal will be done offshore, most likely in Europe and Asia, where the SEC has decided, perhaps unwisely, that it should not tread. That’s not a great solution because the securities laws in other countries are much weaker than here but at least U.S. investors are protected because those shares cannot easily be resold back into the United States.
In the meantime, by the end of this year Facebook expects to have more than 500 shareholders thus requiring public disclosure in 2012 of key business information. Alternatively, Facebook may conduct an IPO itself. In either case, the added disclosure will provide potential U.S. investors a fuller and more balanced picture of the company, while protecting the firm and its bankers from baseless lawsuits. That lowers the cost of capital and helps explain why, despite the recent credit crisis, our markets and our legal system remain a magnet for entrepreneurs around the world.
Facebook has its problems as I pointed out in an interview with the San Jose Mercury News recently but they have more to do with the headaches of managing a startup founded by college kids than they do with the securities laws. The SEC, in my view, had been asleep at the switch during the (Bush era) run-up to the recent financial crisis, which was, in fact, the result of deregulation and that helped undermine the morale and impact of the agency. Fortunately, efforts like Dodd Frank and other reforms are slowly if haltingly restoring balance to the regulatory process.
So if Professor Macey feels so strongly about the virtues of an unregulated world, I know a Chinese IPO he can put his life savings into.