Managing Technology

Facebook's Future on the Open Market

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."

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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