Facebook IPO = Everything you hated about high school

(MoneyWatch) COMMENTARY Were you a dweeb in high school, always wishing to be part of the cool crowd? Then you'll feel right at home -- or thrown back into the ravages of hell (depending on your perspective) -- with Facebook's upcoming Initial Public Offering.

The world-dominating social network plans to go public next month at a rumored price of $40 per share, giving the entire enterprise a value of a whopping $100 billion. But that's the share price that you'd get if you were part of the "in crowd." You must know that you're not.

Unless you are stupendously rich, like a billionaire (or an institutional investor with billions at your investment disposal), or incredibly cool (like an actor), or uniquely powerful (like a Congressman), you just don't get shares at the offering price. If you want to go to the IPO party, you are going to have to crash it by buying shares in the feeding frenzy that's likely to mark the first day's trading. That's like crashing the cool kid's party right before they call the cops. Chances are extremely good that you're going to get in trouble almost immediately after they let you get in the door.

To be sure, the notion that you're not cool enough to get in on the ground floor of an IPO is not unique to Facebook. The only truly "hot" IPO that welcomed in individual investors in recent memory was Google's (GOOG) offering in 2004.

Much more common is the way Groupon (GRPN) went public last November. Institutional investors got the shares at $20 and sold them within hours to the huddled masses who wanted in on the deal so much that they were willing to pay as much as $31 on the first day of trading. The cool kids made out like bandits. What happened to the dweebs that they let in just in time to chip in for the (empty) "kegger" and the band, which was half-way through its final song? Those who bought in at $31 are now sitting on a 63% loss. The stock was selling for just under $11.50 on Monday.

Facebook's quarterly earnings statement that was just released on Monday already gives that "party's nearly over" feel. Facebook's year-end 2011 sales were up 88% and earnings soared 64%. But in the first quarter of 2012, revenues rose only about half as much -- 45% in the first quarter compared with the same quarter a year ago. And net profits were down 12%.

Facebook is still profitable, but if their profits start growing far slower than they have been, the rumored offering price of $40 per share -- which equates to some 87 times the richer 2011 profits -- would be ludicrously high.

Of course that's bad enough. But what makes Facebook uniquely "Mean Girls"-ish is more about the funky shareholder-unfriendly provisions come with this deal. You'll find those buried in the legal filing that describes the deal.

Note, for example, the company's net earnings for the full year of 2011 were $1 billion, but "earnings available to shareholders" were just $668 million. What happened to the other $332 million? You have to dig into the footnotes to find out that the company has already pledged $2.4 billion in stock to a group of insiders. The earnings attributable to those shares aren't available to everyone else. In other words, they're letting you in to help pay for somebody else's keg and, in this case, caviar.

And, if you think paying a high price to get the inside track on this deal gives you any control over what happens with the cool group, you'd be sorely mistaken.

As part of the offering, Facebook CEO Mark Zuckerberg is planning to sell enough of his own "Class A common" stock to exercise an option to buy 120 million shares of Class B stock. What's the difference between A and B shares? Those insignificant "A" shareholders (that's you) get one vote per share. Zuckerberg and his "B" shareholders get 10 votes per share. And not only does Zuckerberg get to vote his own shares, he gets to vote on behalf of the holders of 488.9 million additional super-powerful "Pinky & the Brain"-like B shares for which he is the "proxyholder."

The bottom line? Zuckerberg has 57% of the voting control, even though he only owns about 28% of the stock. (Cue the evil laugh: Bwa-ha-ha-ha-ha!)

By the way, normally the board of directors of a public company must be approved by common shareholders and they break into committees so that "independent" directors will be able to oversee managers on some elements of key importance, like the veracity of the company's financial statements, executive pay practices and mergers. Not so here.

I quote from the company's legal filings: "Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation, or sale of all or substantially all of our assets. This concentrated control could delay, defer, or prevent a change of control, merger, consolidation, or sale of all or substantially all of our assets that our other stockholders support, or conversely this concentrated control could result in the consummation of such a transaction that our other stockholders do not support. This concentrated control could also discourage a potential investor from acquiring our Class A common stock due to the limited voting power of such stock relative to the Class B common stock and might harm the market price of our Class A common stock. In addition, Mr. Zuckerberg has the ability to control the management and major strategic investments of our company as a result of his position as our CEO and his ability to control the election or replacement of our directors."

And that holds true even after he dies: "In the event of his death, the shares of our capital stock that Mr. Zuckerberg owns will be transferred to the persons or entities that he designates."

And here's a conundrum: "As a board member and officer, Mr. Zuckerberg owes a fiduciary duty to our stockholders and must act in good faith in a manner he reasonably believes to be in the best interests of our stockholders.....[but].... As a stockholder, even a controlling stockholder, Mr. Zuckerberg is entitled to vote his shares, and shares over which he has voting control as a result of voting agreements, in his own interests, which may not always be in the interests of our stockholders generally."

Is a board that controlled likely to act in the interest of shareholders? You never know. But here's one little clue: Mark Zuckerberg's dad apparently provided some start-up financing back in 2004 and 2005, for which he got an option to buy 2 million Facebook shares. The option expired, without being exercised. But the board said it "determined that the option did not reflect the intent of the parties with respect to the equity to be issued to him in consideration of the financial assistance and a release from potential related claims."

Thus it gave him 2 million Pinky & the Brain-B shares. Assuming these shares are worth the rumored offering price of $40 each, that's a nice $80 million thank you. How much financial support did he provide the company in those early years? The legal filing doesn't say, but according to Facebook's "timeline," total revenue in 2004 was $382,000; in 2005, it was $9 million. If the total cost of revenue amounted to anything less than that, he got about a 10-fold return on his investment. Quite a generous little thank-you gift.

Now 27-year-old Zuckerberg may feel that this offering is his best revenge, allowing him to turn the tables on the cool kids while becoming one himself. But I think that the best thing about high school is that it lasts just four years before you grow out of it. And you never have to go back. 

Comments

Market Data

Market News

Stock Watchlist