What Is Facebook Afraid Of?

I don't know if you heard, but Facebook finally kicked off the regulatory process of going public. Amid the financial data and business plans the company filed in an S-1 report Wednesday night, you'll also find a list of risk factors. These are the roadblocks and speed bumps that could derail Facebook's gravy train, rip the guts out of your personal investment, or both.

Risk-factor lists in SEC filings don't have to be presented in any particular order, but the discussion must be "organized logically," and many companies rank them by threat level anyway. That goes with the "plain English" requirements of these presentations, and it's also plain good manners toward your current and prospective shareholders. Looking at Facebook's list, I believe that the social network's lawyers and PR people stuck with that principle, so I'm assuming the risks are ordered from the biggest danger to the smallest.

In the filing, Facebook lists 38 business risks and 12 additional hazards for owners of the stock. Nobody ever got sued for listing too many business risks, but the sheer bulk forces me to pick a few cherries. So here we go.

Risk No. 1: We need users
"If we fail to retain existing users or add new users, or if our users decrease their level of engagement with Facebook, our revenue, financial results, and business may be significantly harmed."

It doesn't take a genius to figure out that Facebook needs lots and lots of users to keep the gravy train a-rolling, or that they need to be motivated to keep using the service. Without ad-clicking customers, Facebook is nothing. In this regard, Facebook is no different from Google (NAS: GOOG) or Yahoo! (NAS: YHOO) , which also depend on ad clicks for their very lifeblood.

This one absolutely belongs at the top of the list.

Risk No. 2: We need advertisers
"We generate a substantial majority of our revenue from advertising. The loss of advertisers, or a reduction in spending by advertisers with Facebook, could seriously harm our business."

That's the flipside of the same advertising coin. Tons of customers don't help a lick if the ad feeds are empty. Moving on.

Risk No. 3: Mobile users hurt
"Growth in use of Facebook through our mobile products, where we do not currently display ads, as a substitute for use on personal computers may negatively affect our revenue and financial results."

This one might be a shocker. Smartphones and tablets just don't feel complete without a Facebook app, right? But the explosive growth in mobile computing isn't all wine and roses for Facebook, because the apps don't come with company-backed ad feeds. Until Zuckerberg figures out how to monetize mobile platforms, this trend will be a drag on financial results.

Risk No. 4: We don't own iOS, Android, or HTML standards
"Facebook user growth and engagement on mobile devices depend upon effective operation with mobile operating systems, networks, and standards that we do not control."

This business rests squarely on technologies that other companies and non-profit organizations control. The filing further bemoans, "There is no guarantee that popular mobile devices will continue to feature Facebook," giving Google and Apple (NAS: AAPL) the power to change their standards and kill mobile Facebook apps at any given time. Likewise, Facebook can't promise that HTML, Flash, or any of the other technologies underfoot will be there forever. Maybe the next hotshot standard just won't work with Facebook.

Think about Adobe Systems (NAS: ADBE) and Apple jockeying for years about Flash support in iOS devices. Adobe lost that skirmish; Facebook might lose the next one.

I wouldn't lose any sleep over that possibility, though -- at least not until one of the other threats kills the company. New Web or mobile standards that just won't work with one of the world's most popular online services don't make any sense.

Risk No. 11: We might move too fast sometimes
"Our culture emphasizes rapid innovation and prioritizes user engagement over short-term financial results."

In even plainer English, Facebook might disappoint investors because the financial results are not as important as the hunt for more users. This one pairs up with Factor 29: "We cannot assure you that we will effectively manage our growth."

Stretch that risk out a bit further, and it's easy to imagine one small miss cascading into bigger and bigger flubs, made worse by bigger impacts for one quarter to the next. Before you know it, the balance sheet is empty and there are still bills to pay.

Digital-video pioneer Netflix (NAS: NFLX) often catches flak along these lines. That company is also chasing new customers with every weapon in its arsenal, but the subscriber counts stands at the tens of millions instead of Facebook's hundreds of millions. It's just harder to get a billion customers when they have to pay for a subscription. But the principle is the same, so if you hate Netflix for running after users like a lecher on his first Vegas vacation, you'll hate owning Facebook as well.

Risk No. 22: Mark Zuckerberg will always be the boss
"Our CEO has control over key decision making as a result of his control of a majority of our voting stock."

That's putting it modestly. Through a complicated web of investor agreements and very interesting bylaws, Zuckerberg controls about 57% of the voting power in Facebook. His megavoting Class B shares are very unlikely to ever be diluted below the 50% mark, and he even gets to choose who grabs that voting power after his own death.

That's absolute, dictatorial power to the Nth degree. This risk statement helpfully explains how this might affect investors: "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."

Make sure you trust this guy before you invest in his company, in other words. I don't know Zuckerberg personally, but handing this level of unconditional trust to anyone less than Warren Buffett makes me queasy. This item easily belongs in the top 5, not way down in the 20s.

Foolish takeaway
In fact, that absolute control is a deal-breaker for me. Zuckerberg reluctantly agrees to share his favorite toy with investors, but we have no say in how the company is run. Even activist investors with billions of dollars in capital assets don't stand a chance at making a difference. Carl Icahn can safely unfriend this company, because his money is no good here.

So if Facebook runs too far and too fast, as we've been warned that it might, the checks and balances that could prevent it from becoming the next MySpace or Friendster sob story just aren't there. It all comes down to one person with enough of an ego to place all these safeguards around his power. And that super-sized ego could very well lead Facebook down some very dark alleys.

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What Is Facebook Afraid Of?

Oct. 28, 2003: Mark Zuckerberg hacked into restricted areas of Harvard University's computer network to create Facemash, a website that pulled the private dormitory ID photos of students, then asked users to compare the pictures of two random students and chose which one was better looking. For the brief period before university administrators shut it down, it proved quite popular.

January 2004: Zuckerberg began to write the basic software to create a universal Harvard social directory, TheFacebook.

Jan. 11, 2004: Zuckerberg registered thefacebook.com domain. Then, on Feb. 4, TheFacebook launched at Harvard University. Mark Zuckerberg, right, and Dustin Moscovitz, co-founder, left; took a semester off in 2004 to further improve on TheFacebook website.

March 2004: Initially restricted to Harvard students, TheFacebook expanded to other colleges, including Stanford University, Dartmouth College, Columbia University and Yale University.

April 13, 2004: Zuckerberg, Dustin Moskovitz, and Eduardo Saverin formed Thefacebook.com LLC, a partnership.

June 2004: TheFacebook moved it's headquarters to Palo Alto, Calif., and received an investment of $500,000 from Peter Thiel.

June 2004: Thefacebook incorporated into a new company, and Sean Parker, a co-founder of Napster, took the job of president for the growing business.

September 2004: Facebook replaced its "User is..." prompt with a "What's on your mind?" question in the newly designed space for posting and sharing status updates called "The Wall." 

September 2004: Harvard students Cameron Winklevoss and Tyler Winklevoss of ConnectU filed a lawsuit against Zuckerberg and other Facebook founders for allegedly stealing their idea for a college social network called HarvardConnection.

July 19, 2005: Then-dominant social networking site MySpace was acquired by News Corp., spurring buzz on the Internet about the possible sale of Facebook to a larger media company.

Aug. 23, 2005: TheFacebook dropped its "The" and became Facebook. Purchase price it paid for the Facebook.com domain name: $200,000.

September 2005: Facebook added networks for high school students.  In December 2005, Facebook reached 6 million users.

2005:  Artist David Choe began painting murals at the headquarters of Facebook in exchange for company stock. Today, the shares he received are worth an estimated $200 million.

2006: A cash flow statement was leaked showing that Facebook had a net loss of $3.63 million for the 2005 fiscal year.

Sept. 26, 2006: Facebook removed its restrictions and allowed anyone 13 and older with a valid email address to join.  A news feed and a mini-feed were introduced, providing easier ways to see what your friends are up to.

May 2007: Facebook Platform launched with 65 developers and more than 85 applications.  Third-party developers quickly followed, building applications to integrate with Facebook. Games such as Farmville and Mafia Wars spread rapidly.

July 25, 2007: A federal judge gave twin brothers Cameron (left) and Tyler Winklevoss, founders of ConnectU, and Divya Narendra until Aug. 8 to flesh out the allegations in their lawsuit against Mark Zuckerberg. Those charges  included fraud, copyright infringement and misappropriation of trade secrets.

December 2007:  Facebook reached 58 million users. With the successful addition of Facebook Platform and video, growth remained strong.  Facebook charted a course toward becoming a general portal like AOL; meanwhile, the choice was made not to aim toward being acquired, as   MySpace.com, YouTube and so many other tech startups were.

June 2008: Facebook settled two lawsuits, ConnectU vs Facebook, Mark Zuckerberg et al. and intellectual property theft, Wayne Chang et al., over The Winklevoss Chang Group's Social Butterfly project. The settlements effectively had Facebook acquire ConnectU for $20 million in cash and Facebook shares valued at $45 million, based on a $15 billion company valuation.

July 2008: The first Facebook iPhone app was released.

August 2008: News broke that some employees reportedly privately sold their shares to venture capital firms at prices that gave the company an implied valuation of between $3.75 billion and $5 billion.

October 2008: Facebook set up its international headquarters in Dublin, Ireland.

February 2009: The "Like" social plug-in was added, allowing users to follow status conversations without having to say anything.  The like button was instantaneously a hit. It's initial purpose has been widely misinterpreted as a positive approval button.

August 2009: Facebook acquired FriendFeed, a real-time news aggregator.

September 2009: Facebook said that its cash flow had turned positive for the first time.

April 2010: Facebook announced the acquisition of photo-sharing service Divvyshot, and introduced Community Pages.

May 31, 2010: Quit Facebook Day was an online event where users vowed that they would quit the social network shortly after widespread criticism was received on the new privacy controls rolled out in mid-May.  Zuckerberg publicly admitted the company had "missed the mark."  An estimated 33,000 users quit the site.

June 2010: Facebook employees sold some shares on SecondMarket at prices giving the company an implied valuation of $11.5 billion

August 2010: Places launched, allowing users to share information about where they are in the real world, so friends can find each other.

Oct. 1, 2010: The Social Network, a film about the start of Facebook, was released to theaters. The film, directed by David Fincher, was met with widespread critical acclaim and won the Golden Globe and Critics Choice Best Picture for the Year. Mark Zuckerberg stated that the film is an inaccurate account of what happened.

November 2010: Facebook added features to its mobile software for Android devices. The number of users reached just short of 608 million, with mobile traffic increasing.  

December 2010:  TIME magazine named Facebook founder and CEO Mark Zuckerberg the 2010 TIME Person of the Year.

January 2011: Equity investors put $500 million into Facebook for 1% of the company, placing its implied value at $50 billion.

February 2011: Facebook added 'Civil Union,' and 'Domestic Partnership' to its Relationship Status options.

February 2011: Facebook application and content aggregator Pixable estimated that Facebook would host 100 billion photos by summer 2011.

June 2011: Facebook partnered with Skype to add video calling as well as a new group chat feature.

September 2011: Heroku joined forces with Facebook for application development using the Facebook Platform.

Sept. 22, 2011: Facebook debuted the new Timeline user interface at the F8 Convention.

October 10, 2011: Facebook launched its iPad app.

December 2011: Membership reached 845 million users.

December 2, 2011: New York Mayor Michael Bloomberg (left) Facebook Chief Operating Officer Sheryl Sandberg (center) and Sen. Charles Schumer (D-N.Y.), react during a news conference on the announcement that New York will be the center of Facebook's new engineering technology initiative.

December 22, 2011: Facebook launched the new profile user interface, Facebook Timeline.

January 24, 2012:  Facebook announced that  "Timeline" would become mandatory for all users.

Feb.  1, 2012:  Facebook filed paperwork to go public, seeking to raise $5 billion on Wall Street in the largest flotation ever by an Internet company.

March 6, 2012:  Facebook launches Messenger for Windows, which gives users of Windows 7  Facebook services without the need for a web browser.

April 9, 2012: Facebook announced that is will acquire the photo-sharing app Instagram for $1 billion USD.

May 18, 2012: Facebook founder, Chairman and CEO Mark Zuckerberg, center, rings the opening bell of the Nasdaq stock market from Facebook headquarters in Menlo Park, Calif. The social media company priced its IPO on Thursday at $38 per share, and beginning Friday regular investors will have a chance to buy shares.


At the time this article was published Fool contributorAnders Bylundowns shares of Google and Netflix but holds no other position in any of the companies mentioned. The Motley Fool owns shares of Apple, Google, and Yahoo!Motley Fool newsletter serviceshave recommended buying shares of Netflix, Adobe Systems, Yahoo!, Google, and Apple, creating a diagonal call position in Adobe Systems, and creating a bull call spread position in Apple. They might not recommend buying Facebook. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check outAnders' holdings and bio, or follow him onTwitterandGoogle+. We have adisclosure policy.

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