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Law of Unintended Consequences

Friday, 25 May 2012 09:45 AM

By Jacob Wolinsky

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The Facebook IPO is the biggest story this week. Numerous stories and updates keep coming out, but at the time of this publication Facebook, the Nasdaq, Goldman Sachs and Morgan Stanley have all been sued.

Nasdaq is the exchange where Facebook is currently trading; almost all tech stocks trade on the Nasdaq. However, reports today state that Facebook is thinking of switching its platform to the New York Stock Exchange, as the Nasdaq has been dealing with disastrous handling of the biggest IPO in history.

Back in 2002, the Sarbanes–Oxley Act (SOX) was passed with nearly unanimous approval as a result of huge frauds such as Enron, WorldCom, and Tyco. The bill was passed to prevent fraud. This clearly has not occurred, as the SEC is uncovering more frauds on a regular basis, especially with some Chinese stocks trading on U.S. exchanges.

What does this have to do with Facebook?

There was a section inserted in the bill called SOX 404, which had a huge impact on small companies. According to the SEC, in 2004 companies with less than $100 million in revenue spent 2.55% of costs just complying with this act. On the other hand, companies with revenues over $5 billion spent a negligible 0.06% of their revenue on compliance with the act.

Having spoken to some small company CEOs, the act has had a huge impact on companies going public. Small companies do not see the need to go public and face public scrutiny and large costs in order to sell stocks to the public.

Statistics tell a similar story. According to the Wall Street Journal, only six companies went public in 2008. This compares to 269 initial public offerings in 1999, 272 in 1996, and 365 in 1986.

Many have argued this is not necessarily a bad thing. Companies should not be going public just for the sake of going public. This is indeed true, as many public companies just go public to make money off foolish shareholders.

However, the lesson of Facebook and many other social media IPOs can lead one to the other conclusion. In most IPOs, the biggest winners are the people who bought into the company early and sell out when the company goes public. Goldman Sachs made huge profits as one of the early investors and reportedly sold its stake on the day of the IPO.

The retail investors miss out on all gains. They wait for the IPO when the stock usually is very expensive. The reason that companies go public nowadays is usually because management sees that they are getting a huge premium on their company and want to sell to unsuspecting investors.

Perhaps repealing part of SOX would have prevented the approximately $20 billion loss experienced by many Americans over the past few days.

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