The Economic Fallout of the Facebook IPO

The fallout from Facebook’s botched initial public offering isn’t over. Far from it.

The already-legendary trading snafus at the Nasdaq exchange cost investors and market makers more than $100 million. It's amazing to think that one of the most highly anticipated IPOs in memory degenerated into a litany of mistakes and misjudgments. Regulators are investigating the IPO, which came out at $38 on May 18. The stock subsequently fell to $25.86 on June 5 -- a drop in value of about one-third. It closed at $31.41 on June 18.

SEE ALSO: Fallen IPOs to Invest in Now

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The latest twist in the sorry saga is the June 6 offer by Nasdaq to pay out some $40 million in cash and discounts to member firms that were "disadvantaged by technical problems." The offer is getting a lukewarm reception. The damage to investor confidence has been so great that new IPOs have essentially come to a halt. All the market volatility associated with the euro zone crisis hasn't helped, either.

In one sense, the debacle involving the social media behemoth simply reemphasizes a hoary insight Wall Street veterans share with individual investors at cocktail parties and investing conferences: IPOs are risky gambles best left to deep-pocketed institutional investors. I think a more nuanced approach toward investing in IPOs is in order. But more on that later.

Facebook's debut underscores a far more pressing issue: IPOs are an endangered species on Wall Street. For example, from 2001 through 2011, the annual number of IPOs by domestic operating companies averaged 90 per year, a shadow of the annual average of 298 from 1980 through 2000. The drop in IPOs is most noticeable among firms with less than $50 million in annual revenues, according to Jay Ritter, finance professor at the University of Florida. (The IPO figures exclude a number of categories, such as real estate investment trusts, spinoffs, banks, foreign companies, and deals priced at less than $5 a share.)

The thing is, IPOs have long represented the kind of dynamic firms that capture investor imagination and generate job and revenue growth. Think Hewlett-Packard, Control Data and Digital Equipment in the '50s and '60s; Nike, Genentech and Microsoft in the '70s and '80; and Google and Amazon.com in the '90s and '00s.

Even before the trauma of the Great Recession and the disappointment caused by an anemic recovery, the economy's underlying dynamism was faltering. For example, according to Ritter and Martin Kenney and Donald Patton, of the University of California, Davis, the 2,766 companies that went public from June 1996 through 2010 employed more than 5 million people before their IPOs, but 7.3 million in 2010 post IPOs -- a 45% increase. Adjusted for inflation, their combined sales increased by 96%, from $1.3 trillion in the year before going public to $2.6 trillion in 2010.

Yet, in an intriguing calculation the scholars estimate that if the IPO creation rate of 1980 to 2000 had stayed the same during 2001-2011, the 2,288 additional IPOs would have created an additional 1.8 million jobs.

What's going on? Some of the IPO slowdown may stem from Sarbanes-Oxley, the tougher accounting and reporting reforms enacted after the collapse of Enron, WorldCom and other highfliers in the early 2000s.

Regulators have tried to limit Wall Street conflict of interest by shoring up the so-called firewall between investment bankers and research analysts. One effect of the rules has been to cut down on the number of Wall Street analysts willing to follow small, newly minted public companies.

Yet the far bigger impact lies with economics, not public policy, according to a persuasively argued research paper, Where Have All the IPOs Gone? by Ritter, Xiaohui Gaoa, at the University of Hong Kong, and Zhongyan Zhuc, of the Chinese University of Hong Kong. For one thing, the returns on small-company IPOs have been abysmal over the past several decades -- and investors have noticed. For another, the economy is increasingly a "winner take all" game. The combination of rising globalization and rapid technological innovation creates a competitive environment that favors a handful large of top performers in industry after industry. In a winner-take-all scenario, it makes financial sense for small innovative firms to sell out to bigger competitors rather than go public and fight for a share of markets and profits. "Especially in technology, getting big is more important than it used to be," says Ritter.

The lure to innovate remains. It's how entrepreneurs profit from their innovations that has changed. I think there are reasons for concern in the shift from innovative companies offering IPOs to selling out to the bigger fish. For one thing, what will be the long-term impact on economic growth from the rising concentration of wealth and income in the U.S.?

Economists Robert Litan and E. J. Reedy found in a recent Kaufmann Foundation study that in the 1990s new establishments opened for business with about 7.5 jobs, on average, compared with 4.9 jobs in the 2000s. The risk is that over time talented innovators will decide it's smarter to work for the behemoths -- good pay, good jobs and job security -- rather than taking a flier on starting their own companies. Entrepreneurial innovation and winner-take-all markets collide at some point.

In the meantime, individual investors who are tempted to bet on an IPO should stick with the bigger companies. Google was a multibillion-dollar company before it went public in 2004 at $85 a share. It closed at $570.85 on June 18. Microsoft, EBay, Amazon and other well-known IPOs were already generating hefty revenues before tapping the public markets.

Consider this: From 2001 through 2009 small company IPOs (pre-issue sales of less than $50 million in 2009 dollars) underperformed the relevant market benchmark index by 19.6 percent during the three years after going public. In contrast, says Ritter, large company IPOs (more than $50 million in inflation-adjusted pre-issue sales) out performed their relevant index by 12.9 percent. In other words, investing in Facebook, a big company, may well turn out to be a smart move over the long term. Among its IPO investors is Professor Ritter. For now, he's optimistically holding onto his shares.