Facebook IPO - First Impression

It all started in 2003 in his dorm. Mark Zuckerberg created Facemash, and uploaded pictures of fellow Harvard students online; placing two pictures next to each other, he let viewers rate which one is ‘hotter’. In a matter of 4 hours, the site attracted 450 viewers and 22,000 photo views. Mark was eventually charged by the Harvard administration for a security breach, and violation of copyrights. He faced expulsion, but the charges were dropped later. 

A semester later, inspired by an editorial in The Harvard Crimson about the Facemash incident, Zuckerberg launch Thefacebook on 4^th February 2004. While membership was restricted to Harvard students in the first month, it expanded to Stanford, Columbia, and Yale in March, and later to other Ivy League schools along with MIT, NYU and Boston University. It was soon present in all universities across US and Canada, and in 2005, allowed high schools and major corporations to join too. In September 2006, it was open to anyone who’s older than 13 and had a valid email. Little did he know during his Harvard days that 8 years later Facebook would become the hottest piece of digital real estate and a multi-billion dollar company. With around 845 million active users already, if Facebook were a country, it would be the third most populous one after China and India. And as far as numbers are concerned, that’s just the beginning. Everyday, the social networking site attracts roughly 500 million active users, who upload close to 250 million photos and ‘like’ or comment on 2.7 billion pages. Globally, one in every seven minutes spent on the Internet, and one of every five pages viewed online, are on Facebook.

On 1^st February 2012, Zuckerberg announced plans for a $5 billion Initial Public Offering – the largest tech IPO since Google in 2004 – valuing the company around $75 – $100 billion. The upper-end of that range would value the company at 100x last year’s profits, or about 25x trailing 12-month sales, which, according to Bloomberg, is more than double compared to Google’s valuation when the search giant went public in 2004 (same year as Facebook was launched). The company generated $3.7 billion in revenue and $1 billion in profits last year. According to the Economist, such a valuation would make it more valuable than Boeing, the world’s largest aircraft manufacturer. While that is by no means cheap, other tech giants are worth even more. Based on market capitalization, Google is worth $190 billion, Microsoft is worth $250 billion, and Apple is approaching $500 billion.

When one thinks about the commercial possibilities that Facebook offers, multi-billion dollar valuations are justified. According to Boston Consulting Group, 3 billion people will be online by 2016. Furthermore, mobile Internet usage is rising at double-digit rates. About 425 million people already access Facebook using mobile devices (including tablets). Speculation aside, the one thing that one can be rest assured about is that more and more users spend more and more time on the website (or its mobile app), be it chatting, playing games, sharing news articles, listening to music, or uploading (and commenting on) pictures and videos. Currently, the average user spends around 20 minutes on the website per visit. By ‘liking’ pages affiliated to businesses, sports teams, activities, stories, events, personalities, etc., users associate themselves with lifestyles and brands, and hence create the digital persona they want. And now, with the Timeline layout, they can build a chronicle of their lives too. This is invaluable for large and small businesses alike, both from an advertising perspective as well as consumer research perspective. That Facebook has an information database with such details about its users, and what it could potentially do with it, is another matter altogether. But one thing is certain; the social networking site, now translated into over 100 languages, already has one in every eight persons in the world signed up, and once it breaks into China (where it is still currently banned), it would become an even more attractive platform for businesses (and perhaps even governments).

There is no doubt that Facebook is an exceptional company in terms of its popularity and growth. However, as far as its IPO is concerned, the key question one should ask is why is it going public in the first place? Usually when companies go public, they raise money (by issuing common stock) to invest it in growing their business. So what does Facebook want to raise the funds for? What is Zuckerberg planning to do with the money? How will it help the website grow its business?

       

In its first prospectus filed with the US SEC (Securities and Exchange Commission), the company reported revenues for 2011 worth $3.7 billion, 88% higher than 2010, and net income at $1 billion, which was a 65% rise from the previous year. Hence, it would be fair to conclude that the website can generate adequate internal cash flow to fund operations and expansion (including potential acquisitions). So it makes little sense to raise funds for operational requirements alone. It has after all achieved astounding growth as a private company. So when the prospectus says that the company intends to use the IPO proceeds for working capital and general corporate purposes, I take that with a pinch of salt. Furthermore, it admits that the company does “not currently have any specific uses of the net proceeds planned.”

This brings us back to our main question; if it doesn’t need the money for growth, why is it going public? Facebook answers this question itself. The prospectus states that the “principal purpose” of the IPO is to “create a public market” for its shares and to make the equity stake of the existing shareholders (including employees) more valuable and more liquid. In other words, they are going public to cash themselves in. This is great news for existing investors, but not so much for those who plan to buy its shares via the IPO or in the secondary market.

In a personal letter included in the SEC Filing, Mark Zuckerberg said,

“We’re going public for our employees and our investors. We made a commitment to them when we gave them equity that we’d work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment. As we become a public company, we’re making a similar commitment to our new investors and we will work just as hard to fulfill it.”

The prospectus also states that a portion of the money will be used to pay a portion of the tax obligations related to the initial settlement of RSUs, which in simpler words means that the company would pay off some of the tax due on converting shares given to employees as a part of the IPO. Interestingly, the company intends to invest the proceeds in government securities and term deposits, “pending other uses”. And while the company may use proceeds for acquisitions of complementary technologies and assets, it has made no such commitments yet. Once again, it does not seem like Facebook has a clear idea of what it intends to do with the money.

Another thing worth noting is the arrangement of shares offered. Only Class A shares, which have one vote per share, will be available to public. However, the current board will retain their Class B shares, which have 10 votes per share. Simply put, the IPO is structured in such a way that Mark Zuckerberg (founder, chairman and CEO), who currently owns 28.4% of the company, along with the incumbent management (including the COO, CFO, VPs, other Directors, etc.) will retain majority voting-rights. Hence, the new shareholders will have no say in running the company whatsoever. This is another negative for new investors, even though one can argue that it was expected anyways.

Finally, the company intends to retain its earnings for operational use. This is a deterrent for the class of investors who seek regular dividends. Facebook has never declared or paid any dividends, and does not plan to either. However, considering that the likes of Berkshire Hathaway and Apple (who traditionally were strictly against dividend payouts for many years) too declared a dividend recently, it won’t be a surprise to see Facebook follow suit at some point in the future.

As I’ve already mentioned before, Facebook is an exceptional company. It surely has cemented its place in our daily lives, and has arguably changed the way people communicate, consume and share information. It has given individuals an opportunity to create a digital identity unlike none other. As an organization, it has achieved tremendous growth in very quick time. And it has certainly made its employees and investors a lot of money. However, is its IPO just as exceptional? Will it also achieve the same growth? Will it be able to make the same kind of money for its new investors as it has for its existing investors? Many a times, investors fail to distinguish between a good business and a good investment. As much as I love Facebook as a user, as an investor I am not yet fully convinced about the site’s capacity to translate its impetus into exceptional profits.

That being said, I want to do a follow-up on Facebook, covering possibilities that do make the Facebook IPO attractive, even at such exorbitant valuations.