Keep Facebook Shares out of Users' Hands

 | Feb 01, 2012 | 12:00 PM EST
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This story originally appeared on Real Money Pro.

Lucky for Amazon (AMZN), headlines are being stolen by Facebook today as folks await the company's S-1 filing.

There are several rumors around the filing making their way around and there is only one so far I do not like. Facebook making its IPO shares available to some of its 800 million users would be a giant mistake in my opinion. It would be a monumental mistake, in fact, and I hope and pray that Morgan Stanley and Goldman Sachs do not let this happen. Then again, it worked out so well for Vonage (VG).

Seriously, there will be plenty of demand for shares if the company looks to raise $10 billion and even more demand if it only raises $5 billion. Putting the shares into users' hands will probably be sloppy. I'm fairly certain those shares would have a lock-up period, which many people would not understand, so then we would have the mass confusion of folks trying to sell the initial pop and unable to do so. Then, if Facebook broke its IPO price before users had a chance to sell, the inevitable lawsuits would follow. The consideration may be there to build goodwill, but it is a bad business move for the company and existing shareholders. They simple do not need to do it.

Users are loyal to the product. Giving them the ability to buy 10 shares or 50 shares will not make them any more loyal. It won't increase their time on the site over the long run or their potential spending.  What it will do is create one very big potential liability about the time Facebook is getting ready to unlock shares and about the time it will be reaching a post-IPO prove-it stage.  That's the time after the IPO where Facebook will have to support its valuation with a strong earnings report and strong guidance. As a current Facebook shareholder, I say "do NOT do it." If I wanted to look for a reason for a quick exit, which I don't want, this would be it.

Even with that said, I do love the fact that almost everything I am reading is pessimistic. It's as if the lead underwriters for Facebook are the Mayans. It's 2012. It's the end of the world. What wasn't translated from the Mayans was they meant it was the end of the financial world and Facebook's IPO would be the bringer of destruction. It is to the markets what the Stay Puft Marshmallow Man was to New York City. Where are the Ghostbusters when you need them?  They've got a job to do.

The pessimism is great. Everyone is telling folks to wait. It's hard to disagree, but the question here is what happens if Facebook does get the $100 billion valuation, but only floats $5 billion in shares? What happens when it gets into the S&P 500? What happens when its valuation lands it in the top 50 in the world? Are there going to be enough shares for large-cap fund managers and ETFs to get the proper exposure? The answer is no. There simply will not be enough shares. It is the one argument I have not seen. Cisco Systems (CSCO) has a valuation just north of $100 billion and the Vanguard Total Stock Market Index Fund holds 63.6 million shares, or about $1 billion worth of CSCO. The SPDR (SPY) holds $800 billion worth of CSCO. In fact, the top 10 major Fund/ETF holders of CSCO shares own $6.7 billion worth of CSCO. 

Does anyone else see the potential issue here? Granted, Facebook is not just going to jump into any major indexes from the start, but there will be institutional buyers both in the IPO and in the aftermarket. If Facebook only sells $5 billion, yes ONLY $5 billion, then I feel demand will far outstrip supply just on the institutional side. Furthermore, if we see Facebook added to the S&P 500, then a secondary will be needed just to meet the required weighted allocation of shares into that fund. Dilution will be virtually non-existent because demand will swell to meet it. Demand will be forced, which is ironic when you think of the definition of the word demand.

None of this guarantees Facebook shares will soar out of the gate. None of this guarantees Facebook won't create a bubble or the financial end of the world. But all the negative news makes for sensationalism and fantastic journalism.  There will be demand for the shares, and unlike Doug Kass I don't believe Facebook will break its IPO price on the first day, nor do I think it will be priced at $70 billino as long as Facebook does not make its IPO available to users.

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