Published in Knowledge@Wharton
LinkedIn went public with a bang last week, opening at 84% above its initial offering price on the first day of trading and, after shares continued to climb, closing out the day valued at an impressive — and unexpected — $9 billion.
Within the next year, Facebook is expected to follow LinkedIn’s lead and become a public company. Beyond speculation about what LinkedIn’s success means for Facebook’s IP or other social media companies like Zynga, Groupon and Twitter, experts wonder how going public will change the social media giant as a company. Once shares of Facebook are being traded on the open market, the company opens itself to greater scrutiny and a level of transparency that could expose its weaknesses.
“Suddenly everyone will be able to see Facebook’s business, how profitable it is, the risk factors and how the company is managed and governed,” says Luke Taylor, a Wharton finance professor.
The same day that LinkedIn made its debut, Facebook chief operating officer Sheryl Sandberg described her company’s IPO as “inevitable.” “It’s a process that all companies go through,” she said at the Reuters Global Technology Summit, according to press coverage. “It’s … the next thing that happens. People used to ask us if we were going to get sold. People have stopped asking that question…. No one is buying us; we’re going public.”
Facebook may not have much of a choice. Under U.S. Securities and Exchange Commission rules, any private company with more than 499 shareholders must make public financial disclosures. The Wall Street Journal reported on May 1 that Facebook’s earnings before interest, taxes, depreciation and amortization may top $2 billion for 2011. In January, Goldman Sachs and Russian investment firm Digital Sky Technologies invested $500 million in Facebook, giving it a $50 billion valuation. The deal allowed Goldman’s private clients to invest in a special vehicle that holds shares of Facebook on their behalf, rather than buying into the company directly. That structure led to questions about whether, in the eyes of the SEC, the investment counted as one shareholder or many. More speculation followed as to whether Facebook would pass the 499-shareholder mark, with investors ranging from venture capital firms to mutual funds run by T. Rowe Price. Facebook has reportedly met with bankers to discuss an IPO timeframe, and it is rumored that the company would go public by April 2012.
Although Facebook’s venture capitalists are likely to want a “liquidity event” to cash out, the company historically hasn’t been in any rush to go public. Along with Zynga, Twitter and Groupon, shares of Facebook have been trading on private markets, where exchanges are restricted to employees, qualified institutions and high-net worth individual backers. The SEC has launched an inquiry into private markets like SharesPost and SecondMarket, which are largely unregulated but are growing significantly as employees and early investors seek to participate in the success of Facebook and other social media superstars. On SharesPost, Facebook is the most heavily traded company with an implied value of more than $70 billion. Facebook’s ad revenue is estimated at approximately $4.05 billion in 2011, according to digital media research firm eMarketer.
“Facebook is an example of how the dynamics of public offerings have changed over the past 10 years,” notes Kevin Werbach, a Wharton legal studies and business ethics professor. “Sarbanes-Oxley and other regulations on public companies make IPOs less appealing, and the growth of secondary markets in private stock dissipates some of the pressure for fast-growing startups to go public quickly. In many ways, Facebook is like a public company. It is subject to significant media scrutiny, its revenues are widely reported and it has access to a significant base of investment capital, if not the public markets.”
Given the attention surrounding Facebook, it is possible to dismiss the company’s IPO as a mere formality. But in addition to greater transparency, a publicly traded Facebook would also have to grapple with new pressures to meet quarterly earnings targets and to balance those expectations with its long-term growth strategy. The company culture is likely to change as newly minted millionaire employees cash out their shares and potentially leave for greener pastures. Finally, Facebook will have to stay nimble and focused enough to maintain the edge that made it such a success in the first place.
Headed for a Quarterly Life Crisis?
Simply complying with Sarbanes-Oxley could be a burden for Facebook. The Act contains sweeping provisions in such areas as auditor independence, corporate responsibility, improved financial disclosure, analyst conflict of interest and accountability for corporate criminal fraud. Among other things, the legislation specifically requires chief executive officers and chief financial officers to personally attest to the accuracy of earnings reports and other financial statements. It also sharply curtails the kinds of non-auditing consulting services that outside auditors can provide to companies whose books they review. It protects whistle-blowers, and requires investment firms to take steps to improve the objectivity of reports by securities analysts.
In Facebook’s case, the company will likely have to retool internal processes, such as accounts payable and receivable, in order to adhere to the law. Facebook will have to hire more administrative workers as well as lawyers to maintain compliance, says Taylor, adding that “Facebook is already a big company, but Sarbanes-Oxley represents one extra cost.”
On the whole, relatively young, private companies like Facebook typically have more informal processes than established public firms, according to Wharton management professor Lawrence Hrebiniak. For example, only one management signature may currently be required to pay someone. Sarbanes Oxley requires two sign-offs. “The challenge for Facebook will be to keep top executives focused on strategy and not regulation,” says Hrebiniak.
Meanwhile, Facebook will also encounter what Taylor describes as the “immense” pressure to meet Wall Street estimates and end every quarter on a profitable note. “A company goes public and is suddenly accountable to public shareholders and pension funds,” Taylor says. “Those directors and shareholders have a different mindset from a venture capitalist, who realizes you need to take big risks and swing for the fences.”
Indeed, former IPO darlings Google and Amazon both faced the tug of war with Wall Street in their respective first quarter earnings reports for 2011. Analysts questioned whether Google could manage its expenses as it continues a hiring spree and infrastructure buildout. Amazon missed its first quarter estimates because it added employees, distribution centers and computing power for future growth. “It’s a constant battle to justify capital outlays,” notes Wharton legal studies and business ethics professor Andrea Matwyshyn. “Going public will limit the flexibility Facebook has to invest in long-term projects that don’t bear fruitful revenue streams.”
To hit the right balance with investors, Facebook will need to hire a team just for analyst and investor relations, according to Hrebiniak. “Facebook will have to get close with Wall Street analysts and manage that relationship.”
Under the Public Microscope
Along with quarterly earnings reports and SEC filings comes scrutiny over more than just Facebook’s profits. The annual salary and bonus of CEO Mark Zuckerberg, who has been called the youngest-ever self-made billionaire, will become public record. The risks that keep the Harvard dropout and Facebook mastermind up at night will also be disclosed. So will details about the amounts that top executives earn from cashing out their stock.
A higher level of disclosure may lead to lawsuits over everything from user privacy to shareholder actions, according to Matwyshyn, who predicts that Facebook’s privacy practices, security and spending habits will all be put under the microscope. “Facebook’s additional disclosure will bring legal risks,” she says. “There will be more oversight and consumer protections.”
Matwyshyn notes that law firms frequently sift through regulatory filings looking for any mistake or lack of disclosure. A high-profile company like Facebook will be an easy target for shareholder lawsuits, which — though often lacking in merit — can be expensive to resolve. “The increased scrutiny will open a Pandora’s Box,” adds Hrebiniak.
Facebook’s competitors are likely to comb through the company’s IPO prospectus to look for weak spots and a competitive edge. “Facebook’s IPO filing will be good reading,” says Matwyshyn, adding that Facebook could choose one of two different approaches to its IPO filing, known as an S-1. The company could be highly detailed and disclose all of the risks. The other approach would be to disclose as little as possible. “The tenor of that disclosure will signal Facebook’s overall approach with investors,” she suggests.
Meanwhile, the company is likely to run into new questions about the amount of privacy it offers users, the type of personal information it collects from them and how that data is used. Facebook’s handling of those issues could affect its market capitalization, according to Matwyshyn. “Facebook has walked a fine line on privacy in the past and that’s going to happen again. The risk is that new privacy issues will emerge as Facebook evolves its business model and becomes more conscious about revenue streams and hitting their numbers.”
Faced with pressure from Wall Street, Facebook will need to focus more on monetizing its services, says Wharton entrepreneurship management professor Raffi Amit. But the company “has to be very careful that the focus on making money doesn’t adversely affect its popularity.”
Corralling a Culture of Millionaires
Facebook employees, meanwhile, “have been waiting for this moment for a long time,” according to Taylor. However, once those chips are cashed in, Zuckerberg’s challenge will be to motivate his troops. Will Facebook millionaires maintain focus? Or will those employees move on and force Facebook to hire another generation of workers?
“Facebook’s IPO will be a massive liquidity event for thousands of employees,” Werbach says. “Many of them have already monetized at least some of their stock options through private secondary market activity, but the IPO will still be a massive wealth transfer. It’s difficult to retain employees who have already made millions of dollars on their stock options.”
IPOs typically lead to a “major change in the culture of the company,” adds Amit. As a result, Facebook will have a transition period as it resets from a startup to a public company.
Zuckerberg appears to be preparing for that new era with hires like COO Sandberg, a former Google executive. But Taylor questions whether Zuckerberg would remain CEO for the long run. He could step back to become chairman, or take a role focused on strategy and technology. That blueprint is common: Yahoo founders Jerry Yang and David Filo yielded to Tim Koogle as the company neared an IPO. Google brought on Eric Schmidt to be CEO and formed a management team with co-founders Larry Page and Sergey Brin, although Page has since taken on the top job.
However, others expect Zuckerberg to continue as CEO for a long time to come. He’s the face of the company — known even to the non tech-savvy thanks to the Oscar-winning movie The Social Network, and to moves like donating $100 million to the Newark, N.J., school system.
“Zuckerberg has had plenty of opportunities to bring in ‘adult supervision’ as CEO of Facebook. The current private market valuations are based on him being in charge, so I don’t see why the IPO would change [that],” Werbach says. “Zuckerberg has experienced executives like Sandberg around him. Facebook might beef up its management team as part of going public, but I would be surprised if Zuckerberg doesn’t stay as CEO for an extended period of time.”
The best thing Facebook has going for it as the company moves toward an IPO is the potential for future growth, Werbach adds. “Even at 600-plus million users and several billion dollars in annual revenue, Facebook is small, relative to the opportunity going forward. The challenge for Facebook will be to keep its focus on the opportunity to truly change the world and establish an enduring brand as Microsoft and Google have.”
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