8 Unanswered Questions About Facebook's Finances

If Facebook made a profit of $400 million on revenues of roughly $2 billion last year -- as the New York Times and the Wall Street Journal both reported in January -- then why did it need to take $1.5 billion in financing from Goldman Sachs (GS) just two weeks later?

I'm always slightly suspicious of "profitable" companies that can't get by without selling equity, especially when those companies are in industries with extremely low operating costs (it's not as if Facebook needs to build new factories or open stores like a regular business would). We don't really know what Facebook's finances are like. The NYT and WSJ didn't report that they'd seen the Goldman/Facebook private investor prospectus, merely that they had talked to someone who had seen them.

While there's no evidence that there is anything wrong with Facebook's finances, there are plenty of questions about the quality of Facebook's revenue streams, much of which are supposed to come from advertising. Any investor, such as Goldman's clients, would surely want them answered before they invest in the company. Here are those questions:

What are Facebook's real revenue and profit numbers? Reuters reported last year that Facebook's 2009 revenues were $800 million, with "tens of millions" in profit. But The Times this year said it was $770 million in sales with $220 million in "earnings." There's a lot of slippage between these numbers.
What proportion of the revenue comes from advertising clients, and how much comes from fads like Farmville? Advertisers provide a constant stream of new money, but fads explode one year and then disappear the next. Farmville went into freefall last year. Do you know anyone who still plays it, and -- more importantly -- are they still buying things for their virtual farms?
How much money does Facebook actually make from selling advertising? eMarketer suggests it was $1.86 billion last year and will head toward $4 billion this year. Those are staggering numbers given how lousy the ad vehicles on Facebook generally are. When was the last time you clicked on a Facebook ad? In fact, those ads are even worse than you think -- they burn out completely in terms of generating clickthroughs after three to five days, according to Adweek. How much money can Facebook make on just three days of ads per client? And how many clients will return with new campaigns if that is the performance?
Is Facebook a hostile environment for advertisers? On a more long-term basis, Facebook actually trains its users not to click on ads. You don't need to receive something that a "friend" has "shared" with you too many times -- only to be asked by an application for access to all your information -- before you stop clicking on things in Facebook. That kind of environment is death for advertisers.
Just what share of online advertising does Facebook actually take? The bullish case is that it's 23.1 percent of all display ad impressions, and that total U.S. online ad spending is $26 billion. Well, 23.1 percent of $26 billion is $6 billion. Yet Facebook only reportedly captured a third of the dollars its share would suggest it should own.
Does Facebook actually work for the large advertisers who have the kind of ad budgets that it will need to sustain its growth? Look at who is actually advertising on the social network. Its third largest advertiser, allegedly, is a scam site called "Make-My-Baby.com." The ninth largest client is "Official IQ Quiz." Conspicuously absent from the list are Procter & Gamble, Pfizer, General Motors, News Corp., Johnson & Johnson and General Electric, the companies that traditionally spend the largest amounts of money on advertising.
What proportion of its major advertisers' budgets does Facebook actually collect? AT&T's total annual ad budget for all media is $1.87 billion, and AT&T is Facebook's top advertiser. But those big numbers dwindle quickly as you work your way down Facebook's client list. Verizon spends $517 million on ads. InterActive Corp. spends about $500 million on all its sales, marketing and admin expenses. Progressive spends about $500 million a year, but paid for only one-third the number of impressions that AT&T has. If you assume -- generously -- that all of Facebook's top 10 clients spend an average of $500 million on ads, then Facebook would have needed to pick up 20 percent of each client's entire ad budget in 2010. Next year, it will need to pick up 30-40 percent of those same budgets, which rise by about 5 percent a year in a good year, if it is to reach the $4 billion revenue estimate. Bear in mind that none of these companies devote the majority of their budgets to online. The vast majority of their money goes on TV.
Are there laws of gravity that apply to other companies but not Facebook? Two web advertising companies in recent months have claimed to be profitable but, when it came to filing for an IPO, were forced to admit they actually post losses -- LinkedIn and Demand Media. They're both in the same business as Facebook, providing media for online advertisers. (One might point to Twitter as well.)

Facebook may indeed have reached a level of scale massive enough to be profitable. But its business model -- a social network -- isn't fundamentally different from Second Life, MySpace, Tribester, Friendster and TheGlobe.com, almost all of whom demonstrate one thing: Historically, companies that have tried to sell ad space next to social networks have tended to fail.

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Image by Flickr user Max B, CC.

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