Stock Crash Has Created A Bunch Of New Problems For The Company… Henry Blodget    | Aug. 6, 2012

Facebook’s stock crash has done more than blindside investors who figured that no price was too high for the IPO.

The crash has also created a bunch of new problems for the company:

• Lock-up releases will likely lead to hundreds of millions of new shares being dumped on the market over the next six months … and Facebook can no longer do a simple “follow-on offering” to manage this process.
• Facebook faces a massive ~$3 billion tax bill related to its employee stock compensation and can no longer do what it planned to do, which was sell shares to raise this cash.
• Facebook employees now have less incentive to stay at the company than they did prior to the IPO, which may make retention more difficult and expensive.

All of these issues could put additional pressure on Facebook’s share price. Let’s take each in turn.

The Lock-Up Releases …

A huge number of Facebook shares will become eligible for sales in the next year. Realistically, with the stock this far below the IPO price, Facebook can no longer do a “secondary” stock offering to manage this process. As a result, the shares may hit the market in an unpredictable but steady stream, providing an overhang of “supply” that could depress the stock price for a year.

Facebook currently has a “float” (tradable shares) of about 420 million, which were sold at the IPO. This represents 15% of the company’s outstanding shares.

Here are the Facebook lock-up releases that are coming over the next year, as compiled by analyst Ken Sena of Evercore:

FACEBOOK LOCK-UP RELEASES:

• August 15th, 2012 (next Thursday): 268 million shares, 10% of shares outstanding.
• October 14th: 249 million shares, 9% of shares outstanding.
• November 13th: 1.332 billion shares, 49% of shares outstanding.
• December 13th: 124 million shares, 5% of shares outstanding.
• May 17th, 2013: 47 million shares, 2% of shares outstanding.

Over the next 4 months, in other words, 2 billion Facebook shares will become eligible for sale—about 70% of Facebook’s total shares outstanding.

Although the desire of  shareholders to sell may be muted now that the stock is trading in the low $20s, some will undoubtedly want to sell. And if and when the stock rises, more will want to. This will likely create a steady supply of “share overhang,” which will steadily introduce new shares to the market over the next year or more.

Unfortunately, Facebook can’t do a “follow-on offering” to manage this process …

All companies face lock-up releases after they go public. The normal plan is usually to go public and then, assuming the stock rises, to do a “secondary” stock offering within six months. In these secondaries, which companies like Zynga and LinkedIn have done in the past year, the company puts all the shares that shareholders want to sell into a big block and then markets this block to institutional shareholders with a typical management “roadshow.”

The muppets learned their lesson on the IPO.

Secondary offerings typically depress stock prices, in part because they’re often done at a modest discount to the trading price. But they also eliminate uncertainty and “overhang” by lumping all the shares that are sold into a single big trade. Once that trade is out of the way, the market once again focuses on the company’s fundamentals, and the stock trades normally.

Given the massive amount of stock that will become eligible for sale at Facebook over the next year, it is highly likely that the company planned to do a secondary offering after the IPO to smooth this process.

Unfortunately, Facebook’s stock has crashed since the IPO and is now trading more that 40% below the IPO price.

There is no law that would prevent Facebook from doing a formal secondary offering at the current share price, but it would look so horrible that it’s basically a non-starter.

Imagine if the same management and bankers who sold you stock at $38 a few months ago came trooping into your office to sell you new stock at, say, $22, after incinerating 40% of your capital. You would quickly show them the door.

How about a buy-back plan?

Facebook could also try to stop new shares from hitting the market by offering to buy them from employees and existing shareholders itself.

Doing so, however, would create the same “optics” problem.

Facebook just raised capital a few months ago at $38 … and now it’s using that cash to facilitate the exits of existing shareholders and employees while the stock is still trading at a premium price-earnings multiple?

Few shareholders would be happy with that.

So a true share “buy-back” is probably also off the table, unless the stock hits a level that is obviously ridiculously undervalued by any traditional measure—and we’re a long way from that.

(Even at $21, Facebook’s stock is still trading at 30x-35x next year’s estimated earnings, versus 12x for Apple and 13x for Google. Facebook could trade at half of where it’s trading and still have an “above-average” multiple compared to other tech leaders.)

So that means that any shareholders who want to sell Facebook stock when the lock-ups are lifted will likely sell it directly into the market. And that means that Facebook’s stock is likely to face a significant share overhang for the better part of a year—and especially over the next several months.

The Huge Impending Tax Bill …

The next problem that Facebook faces is a massive impending tax bill related to its employee stock compensation program.

Facebook will likely have to write a check for $2.5–$4 billion to the U.S. government in a few months to pay the “withholding” tax on many of its Restricted Stock Units (RSUs), which will vest about 6 months after the IPO.

Fortunately, David Ebersman, Facebook’s CFO, has a Plan B.

Facebook’s primary mechanism for employee stock compensation are these RSUs, which grant employees a certain number of Facebook shares and vest over many years. Many of Facebook’s RSU’s have a “trigger” that causes the shares to vest 6 months after the IPO. When the shares vest, their value (at the vesting price) is treated as compensation to employees, and the company is required to withhold taxes on this, the same way it would with any other compensation.

Facebook has granted a lot of Restricted Stock Units to its employees—more than 400 million at last count.

The vast majority of these RSUs—about 273 million—will vest between October 14th, 2012 and November 13th, 2012, with the specific date to be determined by the company.

After the vesting date, the company will withhold about 45% of the shares covered under the RSUs and then write a check to the government for the value of those shares on the vesting date. In its latest SEC filing, the company estimated that its cash tax bill with the share price at $31 would be about $3.7 billion. If the stock stays in the low $20s, this tax bill is likely to be far lower, perhaps $2.5–$3 billion.

The problem is this:

Prior to its IPO, when it thought its stock would trade higher after the IPO, Facebook planned to raise the money to pay this tax bill by selling the shares it withheld from the RSUs.

Of the 273 million shares Facebook expects to deliver under the RSUs, the company will deliver about 153 million shares to employees and withhold 120 million shares.

Prior to the IPO, the company appears to have been planning to sell these shares in the open market (perhaps through a secondary offering, as described above) to raise the $2.5–$3 billion of cash it has to deliver to the government.

Now, for the reasons described above, this is basically impossible.

Fortunately, Facebook’s CFO David Ebersman put both “Plan B” and “Plan C” in place prior to the IPO, so Facebook certainly won’t face a cash crunch. But it also won’t be able to raise the cash to pay this tax bill by selling stock.

Thanks to Ebersman’s contingency planning, Facebook has $10 billion of cash on its balance sheet, so it could easily write a check to pay the tax bill without significantly constraining its flexibility.

Prior to the IPO, Ebersman also negotiated enormous lines of credit on favorable terms with many of the banks Facebook used to underwrite the IPO, so Facebook could pay its tax bill by drawing on these lines.

Regardless of what source of cash Facebook uses to pay the tax bill, it will be fine. But by effectively losing access to the equity markets, it has lost one potential source for this cash.

Lastly, The Employee Retention Problem …

The other problem that Facebook’s stock crash has created is that it will likely make it more difficult—or, at least, expensive—for the company to retain its employees.

Every Facebook employee who joined the company in the past 18 months, since the end of 2010, is now “underwater” on his or her stock grant (meaning, in this specific case, that the stock price is below the level it was when the employee joined the copmpany).

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Not as much fun as it was three months ago.

The price of the stock for the RSU employee stock grants in the first quarter of 2011 was $24.10 per share, and it went up from there. By the first quarter of this year, the “fair value” of the RSUs when they were granted hit nearly $31 a share. With the stock now trading in the low $20s, this means that the RSUs of all of the employees who have joined Facebook in the past 18 months—perhaps half of its workforce—are now worth considerably less than they were when the employees joined the company.

Importantly, RSUs are much more favorable for employees in these situations than stock options, which effectively have no value below their grant price.

RSUs are composed of actual shares of stock, so they’re worth something to employees as long as the stock has any value at all.

But the current value of Facebook’s RSUs is currently less than at any time since late 2010. This means that Facebook’s “golden handcuffs” on its employees are likely to be considerably less effective than the company expected they would be.

And if Facebook’s stock were to stay at the current level, Facebook might be forced to give some of its employees additional stock or cash as compensation to keep them at the company. And this, in turn, could result in additional dilution for shareholders and/or lower operating margins for the business.

The Bottom Line

The bottom line is that Facebook’s stock crash has created several additional headaches for the company. None of them are life-threatening, but they all could have a negative impact on the stock price.