The Facebook IPO and the role of stories in decision making

     Andrew Ross Sorkin, the well-known business reporter for the New York Times, recently reported on Facebook’s difficulties on the day, May 18, it launched its initial public offering (IPO) on the Nasdaq exchange. The opening share price was $38, but by the beginning of September the stock was selling at $18. As Sorokin writes, “three months after the offering, the company has lost more than $50 billion in market value…To put that in perspective, that’s more market value than Lehman Brothers gave up in the entire year before it filed for bankruptcy.” Sorokin describes this as a "debacle." As the following graph shows, the price was at its peak on the very first day of trading and has been falling ever since,   -->

     To be sure, a company profits when investors overpay for its shares, but the size of the gap between the first day, and its price three months later, undermined the company’s credibility significantly. In addition, while underwriters get a percent of the sales, their customers, for example large institutional investors, hope to profit from the bounce between the value of the stock at the beginning and the end of the first day of trading. If the stock is priced cautiously the bounce can be large. But in the case of Facebook, the opening price on the first day of trading was also the closing price. This meant that the underwriters had many unhappy customers.

     One question is how to interpret this debacle. One hypothesis is that the Facebook’s stock was hyped to begin with. While it has close to a billion users, it is still not clear that Facebook can make enough money by selling advertising. The value of digital ads are falling, Facebook’s revenue per user is falling, and as people increasingly access the site on mobile devices they are less likely to pay attention to ads. According to this way of thinking, either the senior executives of the company believed in the hype, or they purposefully jacked up the price the day of the IPO. 

     The second explanation seems less plausible. After all, it means the firm was willing to sacrifice its reputation for some immediate gains. By contrast, the first explanation seems more plausible because underwriters’ requests for shares on the day of the IPO were in fact very high, suggesting that demand was great. As Sorkin notes, “After a company’s roadshow presentations, investors indicate how many shares they plan to buy. They typically ask for more shares than they expect to receive, sometimes twice as many. But in the case of Facebook, investors, anticipating huge demand, put in requests for triple or quadruple the number of shares they expected to get. The bankers — and Mr. Ebersman (the CFO) — did not seem to appreciate what was happening. They seem to have believed their own hype and took those orders as real, giving them the misplaced confidence to push the IPO to the highest possible price and issue more shares.” In other words, they misinterpreted the demand for shares as evidence of the stock’s value, rather than as evidence for unreasonable expectations about the company’s prospects. 

     This explanation has the merit of confirming the features of any complex situation. As Helga Drummond, the decision theorist notes, “ambiguity always lurks,” data and signals do not connote what they appear to mean, making all important decisions, particular the pricing of an IPO, partly a stab in the dark.

     One question is, how do executives deal with ambiguity? I am drawn to another part of Sorkin’s story. “Another issue that weighed on Mr. Ebersman, as well as the bank underwriters, was the example set by LinkedIn. Its shares rose 110 percent on its first day of trading. That might sound good, but it meant that the company mispriced the shares so badly that it effectively gave investors a gift of nearly $350 million. Mr. Ebersman was intent on making sure Facebook didn’t ‘leave money on the table,’ according to several people close to him. But by leaving investors with little upside, he may have created additional pressure on the stock.”

     Sorkin’s argument highlights the central role stories play when in fact ambiguity lurks. One hypothesis is that we rely on two modes of reasoning when making decisions. The first is algorithmic and depends on logical and quantitative thinking. But when ambiguity lurks we rely more on discursive reasoning through which we dramatize situations.  In this frame of thinking we see the ebb and flow of events as shaped by knaves and fools, or heroes and victims, and we engage in trial runs, before deciding, by alternatively identifying with different characters in the drama. In this way of thinking, we can hypothesize that Ebersman saw himself in the role of LinkedIn’s CFO, facing the prospect that he would experience shame by foolishly leaving money on the table. As this argument suggests, dramas are freighted with emotions that in turn shape our decision-making. 

     One question is why do we dramatize when ambiguity lurks?  One hypothesis is that in the face of ambiguity we may not achieve the conviction we need to make difficult decisions. The data on hand do not reduce our sense of uncertainty. Without conviction we may attenuate our commitment to a course of action when we confront our first unexpected obstacles. But one sure road to conviction is through our emotions when we feel the decision we are about to make, as the phrase goes, “in our gut.” And, as the term “drama” suggests, stories are vehicles for discovering how and what we feel about a situation.

Indeed, it is still remarkable, even if commonplace, that we can moved to tears by obviously fictional accounts, whether in the form of novels, films or plays. Even as we know that what we are experiencing is not true, for example, objectively the movie is an image on celluloid, we are nonetheless moved by the emotional truths works of fiction stimulate. History interprets past events by creating a story about them, and if fiction creates emotional truths, history, which has some basis in fact, should be as persuasive, if not more so, than fiction. This is why for example, we often worry that our generals are always “fighting the last war.” 

     Some management theorists overvalue stories as guides to decision making. They counsel executives to tell subordinates stories that are uplifting and motivating so that people will give it their all to a particular initiative or strategy. But as our worry about the generals suggests, while stories are meaningful, they are not necessarily accurate. For example, the reader may recognize in the Facebook case the operation of what behavioral economists call, “loss aversion.” As economists argue, losing $100 is far more painful than is the pleasure of winning $100. As Sorkin suggests, the LinkedIn story stimulated the fear that Facebook would lose money it was entitled to. In this sense Ebersman was motivated by pain, rather than by greed, and by anticipated shame, rather than by an imagined victory. Stories in other words have all the limitations we associate with day-dreams and fantasies. The unconscious roots of a story, for example loss aversion, can distort judgment as much as it can motivate action. 

     Freud long ago described the difference between what he called the primary and the secondary process. The latter was based on conscious reasoning tied to the logic of cause and effect; the former was based on wishes, fantasies and emotions through which we often sustain contradictory ideas. Today the “object relations” school of psychoanalysis suggests that wishes, fantasies and day-dreams are shaped by our internalized conception of how we relate to others, what roles we play in their dramas as well as in our own. Since, ambiguity always lurks and ambiguity provokes us to rely on stories, this suggests that rationality far from being a foregone conclusion,  is instead an achievement.