Facebook IPO: 5 New Danger Signs For Investors

on April 24 2012 3:13 PM

Assuming the $77 billion initial public offering by Facebook is approved, investors probably will clamor for shares, just as in earlier frenzies for Netscape Communications, Yahoo (Nasdaq: YHOO)  and Google (Nasdaq: GOOG).

But there are some marked differences among those IPOs - in 1995, 1996 and 2004, respectively - and Menlo Park, Calif.-based Facebook's.

They share some of the same underwriters, including Morgan Stanley, which will lead the Facebook IPO.

After combing through initial the initial Facebook filing, we noted several key danger signals. Now, in amended filing that brought developments up to date, here are some more points to bear in mind:

Facebook will be CEO Mark Zuckerberg's kingdom: For better and worse, the 27-year-old CEO will rule the company because Facebook will have two classes of shares. Zuckerberg will control nearly 57 percent of the company, including both his Class A and B shares.

That isn't necessarily bad. Companies including the Washington Post (NYSE: WPO), whose chairman, Donald Graham, is a Facebook director, and Google have them; so does Berkshire Hathaway (NYSE: BRK/A), the investment vehicle of Warren E. Buffett, whose directors include Bill Gates.

Still, the company doesn't have a chairman or a lead director, reforms all recommended after the options scandal ensnared so many technology companies, including Apple (Nasdaq: AAPL), and helped inspire the Sarbanes-Oxley Act of 2002.

Who's going to challenge Zuck in the boardroom? If not Graham, could it be Netscape founder Marc Andreesen, 40, now also a director of Hewlett-Packard (NYSE: HPQ)? Or Erskine Bowles, 66, former White House chief of staff for President Bill Clinton?

The other directors are all Facebook investors and backers: PayPal founder Peter Thiel, Accel Partners venture capitalist Jim Breyer and Netflix (Nasdaq: NFLX) CEO Reed Hastings.

Given their prestige and wealth, perhaps the dangers are mitigated.

When Zuckerberg decided to acquire Instagram for $1 billion, he invited its CEO, Kevin Systrom, to his house, conducted all the negotiations himself and only then notified the board. Is that what future shareholders want?

How to spur more revenue and traffic? Facebook's 2011 revenue was only $3.71 billion, about $2 billion below many estimates, although that was nearly double 2010's performance. Now it reported first-quarter net income fell about 12 percent to $233 million, as revenue fell 7 percent, to $1.06 billion.

Given that Facebook already has 901 million members, about 13 percent of the world population, how can it attract more and generate more clicks that will generate ad revenue?

The prospectus doesn't address that issue, although it points out that the company's reach in many places outside the U.S. is far greater than at home. One obvious place will be to generate more daily clicks. There are only about 526 million now, Facebook disclosed, which means there's a lot of deadwood. We also know that at least 5 percent of members are either frauds or never existed.

Higher costs to sustain uptime traffic. Facebook is only seven years old, and until last year, it didn't even operate its own data center to handle the enormous traffic demands.

The company spent $388 million on research and development last year, more than double the 2010 amount. In the first quarter, the total was $153 million, nearly triple the year-ago amount.

Now it has millions of pages generated by users, billions of pictures and terabytes of data that members want to access NOW!

For sure, some of the $5 billion Facebook wants to raise will go to better infrastructure or to hire a provider, like an HP or Cisco Systems (Nasdaq: CSCO) to manage service.

Patents and intellectual property. In the initial filing, Facebook disclosed holding 56 patents and applications for 503 more in the U.S. alone, as well as 33 foreign patents in hand and another 149 pending.

This week, Facebook announced it will pay Microsoft (Nasdaq: MSFT), the world's biggest software company, $550 million for part of a 990-patent trove it had won in an auction by AOL (NYSE: AOL).

Zuckerberg will get 650 patents outright as well as a license to the others held by Microsoft, which already owns 1.6 percent of Facebook.

The position strengthens Facebook in its patent litigation lawsuits against Yahoo, but the dealings again raise the issue of who approved the deal.  Did Zuckerberg commit another $550 million on his own?

Intellectual property is very hot right now. Surely anything Facebook has is being zealously guarded. That might be one reason Zuckerberg chose Fenwick & West, well-known for patent law, as the company's outside law firm.

Where will Facebook be in 10 years? That's hard to tell. Zuckerberg, despite his letter to prospective shareholders advocating social media and global change, probably doesn't know, either.

But going public and hiring Wall Street investment banks not held in high public esteem means a lot of big investors such as state pension funds and mutual funds will be invited to buy Facebook shares.

Those investors will want a roadmap and specificity, although technology investors know that even for the most solid company, such as HP or IBM, there is no such thing as a perfect course.

If it's any barometer, shares of Google rose Tuesday about $4.82 to $602.42, while those of Yahoo shares rose 7 cents to $15.40. Microsoft shares dropped 23 cents to $31.89.