Facebook IPO: An Investment In Facebook Is An Investment In Zuckerberg

For the all the hype about Facebook’s initial public offering (IPO), analysts are raising important questions that the social network will need to answer to court investors successfully.

On February 2, Facebook filed its Form S-1 with the Securities Exchange Commission (SEC) seeking to raise $5 billion from the sales of Class A common stock. Analysts quickly reported their expectations that the behemoth start-up could be valued somewhere between $75 and $100 billion and that it could likely raise up to $10 billion, setting it up to become one of the largest IPOs in American history.

Most of the enthusiasm stemmed from the company’s potential to increase revenue significantly over the next several years. With 845 million active users worldwide (up more than double from 2010), Facebook made a profit of $1 billion from $3.7 billion in revenue in 2011, 85% of which came from advertising sales. This figure is especially astonishing when one realizes that this 8-year old Internet company does not sell any tangible goods nor charge subscription fees to its users. Additionally, the social network is working on developing other sources of revenue, including fees from a payment platform for developers and social gamers and additional advertising revenue from its mobile application, according to its S-1.

However, skeptics have also been quick to point out possible pitfalls in the social network’s rosy projections. In particular, Facebook has come under especially sharp criticism for its ownership and governance structure. With this IPO, Facebook will now issue two classes of common stock, Class A and Class B. These two classes of stock are virtually indistinguishable except when it comes to convertibility and voting rights. Class B stockholders have the option to convert their stock to Class A stock at a one-to-one ratio at any time. But more importantly, Class B stockholders get 10 votes for every share whereas Class A holders get only one vote per share. Concretely, this means that the social network’s founder and CEO, Mark Zuckerberg, will control at least 57% of the voting rights while owning only 28% of the company’s stock, because of voting agreements and the amount of Class B stock that he holds. This ownership structure gives Zuckerberg near unilateral power to accept or reject any proposal submitted to shareholders for approval.

For example, Zuckerberg’s power includes the authority to appoint the entire board of directors, a level of control that makes some members of the investor community uncomfortable. According to the Wall Street Journal, Anne Sheehan of the California State Teachers’ Retirement System (CalSTRS), a large California pension fund and institutional investor in Facebook’s private stock, has already criticized the current composition of the social network’s board. In a letter to Zuckerberg, Sheehan wrote, “We are disappointed that the Facebook board will not have any woman members. This is particularly glaring at a time when there is clear evidence that companies with diverse boards perform far better than the companies with more homogenous boards.”

In its S-1 Facebook acknowledges the conflict of interest that arises from Zuckerberg’s roles as shareholder and officer, and warns investors that the concentration of power under Zuckerberg is one of the risk factors that they should consider when making their investment decision. In his capacity as Chairman and CEO, Zuckerberg owes fiduciary duties to shareholders, including the duty to make decisions in their best interests. However, as a shareholder, he has the right to vote his shares in his own interests, which the company correctly points out “may not always be in the interests of . . . stockholders generally.”

For this reason, analysts have correctly observed that an investment in Facebook is, in fact, an investment in Zuckerberg. As the investor community digests the implications of this reality ahead of the IPO, it will be interesting to see how Zuckerberg’s leadership factors into the company’s stock price.