M fb snaptu com f

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

This case was written by Wouter De Maeseneire and Anantha Krishna Divakaruni at Vlerick Business School. It is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The case was compiled from field research.

We gratefully acknowledge financial support from CIM/ICM (Intercollegiate Center for Management Science). Copyright © 2012 Vlerick Business School, Belgium. No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of the copyright owner.

The Facebook IPO hype: a rude social awakening

Wouter De Maeseneire

Anantha Krishna Divakaruni

September, 2012

Abstract

Facebook, the world’s largest social network, became a listed company in May 2012. The meteoric rise of Facebook from a Harvard student dorm into a billion‐users platform has fascinated everyone around the globe. Markets had been engulfed with excitement for over a year ever since rumours began to circulate of the company’s planned Initial Public Offering (IPO). In essence, Facebook’s conversion from a much sought after private entity1 into a public firm has been shaped by numerous factors. Lack of credit on favourable terms combined with Facebook’s compensation policy as well as the desire of a couple of influential shareholders to exit their investment prompted the firm to consider an entry into the stock markets. Despite hiring highly reputed and experienced underwriters to facilitate this transition, a series of missteps by several stakeholders encouraged the firm to introduce its shares at an indefensible price. Facebook chose an issue price based on market fads and an alarming level of investor and insider overconfidence; it ignored the estimates suggested by its own valuation models. Further, the company’s frequent and discouraging amendments to its filings with the Securities & Exchange Commission (SEC) eroded the much desired shareholder confidence. This case study describes the benefits and drawbacks of going public, what the IPO process typically entails and the role that underwriting investment banks take up. We highlight various elements that led to the failure of what has been one of the most hyped‐up IPOs ever. Besides discussing the role of various agents in this fiasco, the case reflects on how simple rationale got overridden by the most seasoned titans in the IPO market. In addition, this case delves upon the valuation methods and assumptions that were used by the underwriters to justify an appropriate offer price for the Facebook stock.

1 Especially among venture capital investors.

CASE 2012‐14‐C

112-052-1

Distributed by The Case Centre North America Rest of the world www.thecasecentre.org t +1 781 239 5884 t +44 (0)1234 750903 All rights reserved f +1 781 239 5885 f +44 (0)1234 751125

e info.usa@thecasecentre.org e info@thecasecentre.org case centre

U s a g e p

e rm

it te

d o

n ly

w it h in

t h e s e p

a ra

m e te

rs o

th e rw

is e c

o n ta

c t in

fo @

th e c a

s e

c e

n tr

e .o

rg

T a u g h t b y A

ri f K

h u rs

h e d , fr

o m

2 -N

o v -2

0 2 0 t o 2

8 -F

e b -2

0 2 1 . O

rd e r

re f F

3 8

6 7

9 9

.

P u rc

h a s e d f o r

u s e o

n t h e F

o u n d a ti o n s o

f F

in a n c e , a t T

h e U

n iv

e rs

it y o

f M

a n c h e s te

r W

o rl d

w id

e L

im it e

d .

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

2

CASE 2012‐14‐C

Introduction Friday, May 18, 2012, was a crucial day for Facebook. The day marked the official transformation of the leading social networking service into a public company. Financial markets and investors were charmed over prospects of buying shares of a firm admired by the entire planet. As a result of Facebook’s $16 billion Initial Public Offering (IPO), its Chairman and CEO, Mark Zuckerberg, and over 1,000 early‐investors and employees at the firm would become millionaires or even billionaires overnight. Zuckerberg himself stood to become the 29th richest person on the planet with an estimated net worth of $19.1 billion2. The IPO received widespread coverage in the media ever since rumors of the firm going public began surfacing. Experts estimated the value of the firm in excess of $100 billion, skeptics were essentially ignored and everyone wanted a share of the pie! However, the stock debut proved to be a nightmare for everyone involved. By June 6, the price of Facebook shares3 had slumped to $25.52, a staggering decline of 32.8% below its IPO price at $38. An unproven business model based on ad‐revenues, improper valuation estimates and technical glitches during the initial period of trading were instrumental in weakening appeal for the Facebook stock. Since then, the company has faced over 40 lawsuits and is being investigated for malpractice by the Securities and Exchanges Commission (SEC). Thus, Zuckerberg faces an uphill task of reinvigorating his company’s fortunes and restoring investor confidence.

Rise of Facebook: Pre‐IPO The origins of Facebook can be traced to a briefly existent website called Facemash, which was created by Zuckerberg during his second year at Harvard University. Facemash allowed users to compare two random pictures of female students and choose the ‘hotter’ one amongst the two. Zuckerberg had hacked into Harvard’s servers for obtaining students’ images, which caused much outrage within the female student community4. Although Facemash was closed down by Harvard authorities, Zuckerberg had grasped the power of social networking. He therefore began extensive work on a superior social networking platform together with roommates Eduardo Saverin, Chris Hughes and Dustin Moskovitz. Thefacebook.com was launched on February 4, 2004 and was initially restricted to Harvard students5. During the same year, Sean Parker6 invested in the start‐up and also purchased the domain Facebook.com for $200,000. In a short span, the website expanded to all universities across the United States.

2 http://articles.latimes.com/2012/may/17/business/la‐fi‐tn‐how‐much‐is‐mark‐zuckerberg‐worth‐20120517 3 Stock quotes on NASDAQ by the ticker symbol: FB. 4 http://www.businessinsider.com/how‐facebook‐was‐founded‐2010‐3?op=1 5 http://www.guardian.co.uk/technology/2007/jul/25/media.newmedia 6 Founder of Napster.

112-052-1

U s a g e p

e rm

it te

d o

n ly

w it h in

t h e s e p

a ra

m e te

rs o

th e rw

is e c

o n ta

c t in

fo @

th e c a

s e

c e

n tr

e .o

rg

T a u g h t b y A

ri f K

h u rs

h e d , fr

o m

2 -N

o v -2

0 2 0 t o 2

8 -F

e b -2

0 2 1 . O

rd e r

re f F

3 8

6 7

9 9

.

P u rc

h a s e d f o r

u s e o

n t h e F

o u n d a ti o n s o

f F

in a n c e , a t T

h e U

n iv

e rs

it y o

f M

a n c h e s te

r W

o rl d

w id

e L

im it e

d .

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

3

CASE 2012‐14‐C

By 2006, Facebook was accessible for free to anyone with a valid email address. Zuckerberg was vehemently opposed to selling Facebook and has adopted several strategies to maintain control and independence. His unopposed management style has encouraged quick decisions and led to constant improvement of the platform, dwarfing the likes of famous social platforms such as MySpace and Orkut. In mid‐2012, Facebook had over 901 million registered users (Exhibit 1). Zuckerberg has rejected several takeover attempts, including offers from Yahoo and Google that valued the company at $2 billion. Even Microsoft had to contend with a meager stake of 1.6% after having invested $240 million in 2006, elevating Facebook’s value to $15 billion. Over the years, numerous investors have acquired a share in Facebook at gradually rising valuation levels (Exhibit 2). Much like its competitors7, the site generates revenue from advertising although profits have been realized only since 20098. The latest investment round of $500 million by Goldman Sachs and Digital Sky Technologies in 2011 lifted the worth of Facebook to over $50 billion, provoking massive speculation that the company was preparing for a public offering9. Exhibit 3 provides an overview of key shareholdings and compares Facebook’s value to some of its peers.

Revenue Model Facebook adopted a business model on the lines of tech pioneers like Yahoo and Google. A typical startup relies on a single product and seeks to generate revenues from such sole innovations. Thanks to its Chief Operating Officer (COO), Sheryl Sandberg, Facebook developed an ad‐driven business model10, which allows users to develop personalised advertising campaigns, which are then displayed along the sidebar on appropriate pages. These include users’ home pages, profiles, groups and various third‐party applications that are hosted on Facebook. Ads are displayed to users through granular targeting features derived from individual preferences, topics and variations of words or phrases11. This advertising platform has gained sophistication over the years with capabilities to target audiences based on restrictions like specific cities or regions, age, gender or type of social network12. Corporate customers even have the benefit of using the Facebook Ads API13 for developing customised ad campaigns for dissemination among relevant users.

Financial Performance No information is available in the public domain regarding Facebook’s financials prior to 2007. Between 2007 and 2011, turnover increased 24‐fold from $153 million to $3.7 billion. Revenues from advertising on the primary website constitute over 85% of revenues in 2011. Yet, average annual revenue growth at 88% has been substantially lower than other social networks like Zynga and Groupon at 134% and 426% respectively14. Operating margins have been quite volatile as the company has sought to invest more capital into research and development besides scaling up its workforce to meet growing demand.

7 Most notably, Google and Yahoo. 8 http://www.sec.gov/Archives/edgar/data/1326801/000119312512034517/d287954ds1.htm#toc287954_8 9 http://tech.fortune.cnn.com/2011/01/11/timeline‐where‐facebook‐got‐its‐funding/ 10 http://cdixon.org/2012/05/15/facebooks‐business‐model/ 11 http://www.insidefacebook.com/2011/08/23/topic‐ad‐targeting/ 12 Like family, school, work etc. 13 Application Programming Interface – a framework for developing code for additional functionalities. 14 http://beta.fool.com/apinkasovitch/2012/02/02/analysing‐facebooks‐financial‐statements/1573/

112-052-1

U s a g e p

e rm

it te

d o

n ly

w it h in

t h e s e p

a ra

m e te

rs o

th e rw

is e c

o n ta

c t in

fo @

th e c a

s e

c e

n tr

e .o

rg

T a u g h t b y A

ri f K

h u rs

h e d , fr

o m

2 -N

o v -2

0 2 0 t o 2

8 -F

e b -2

0 2 1 . O

rd e r

re f F

3 8

6 7

9 9

.

P u rc

h a s e d f o r

u s e o

n t h e F

o u n d a ti o n s o

f F

in a n c e , a t T

h e U

n iv

e rs

it y o

f M

a n c h e s te

r W

o rl d

w id

e L

im it e

d .

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

4

CASE 2012‐14‐C

Still, operating performance in 2012 has been anything but supportive of a successful IPO. Just a week before the stock floatation on NASDAQ, Facebook issued an earnings warning stating that the number of mobile users had grown much faster than growth in sales from its mobile platform. The company cited the lack of formidable mobile advertising capabilities for this discrepancy15.

“We believe this increased usage of Facebook on mobile devices has contributed to the recent trend of our daily active users increasing more rapidly than the increase in the number of ads delivered. Our financial performance and ability to grow revenue would be negatively affected.”

Analysts covering the firm interpreted this statement as a warning that Facebook expected to miss revenue and profit targets for the 2nd quarter, and it was a key point of concern for several institutional investors during the IPO roadshow. Despite making inroads into mobile devices through acquisitions like Instagram, Facebook is yet to devise a credible way of monetizing such products. Over 7% of revenues in 2011 were generated indirectly from virtual goods payments on Zynga16. This relatively small but growing revenue source shows much promise for Facebook’s future prospects. Currently, Netflix and the Washington Post Company are Facebook’s largest customers17 and generated $3.8 million and $4.2 million respectively as revenues in 2011. Facebook has paid back all outstanding debt and held $3.9 billion in cash and marketable securities on its balance sheet by the end of 2011. Working capital is also healthy at $3.7 billion due to its comfortable cash base and low net payables. See Exhibits 4 ‐ 6 for the company’s financial statements.

Concerns Natalie Pace of the Huffington Post says that on average, users spend 56% more time on Facebook than Google18. In fact, the former attracts over a 100 billion, or twice the number, of page views in comparison to Google. Despite its information superiority19, Facebook generated a mere tenth of Google’s revenues in 2011. Facebook has also established another important revenue stream by nurturing third party game services like Zynga and Bigpoint. For this, the firm receives a commission fee20, which contributed over 17% of total revenues21, or nearly a third of Facebook’s pre‐tax income, in 2011. This dependence may change due to the evolving competitive landscape. Game providers ‐ like Zynga in particular22 ‐ have developed capabilities for hosting on rival platforms like Google+, Apple iOS and Tencent. Zynga’s revenue sharing agreement with Facebook is valid only up to 201523. 15 http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/digital‐ media/9258915/Facebook‐issues‐profits‐warning‐as‐users‐switch‐to‐mobile.html

16 http://www.insidefacebook.com/category/virtualgoods/ 17 For hosting advertisements on the Facebook platform. 18 http://www.huffingtonpost.com/natalie‐pace/facebook‐ipo_b_1251627.html 19 Access to users’ private details, photographs, messages and preferences. 20 30% of subscription fees. 21 http://www.forbes.com/sites/techonomy/2012/05/23/gaming‐a‐boon‐or‐bane‐for‐facebook/ 22 Accounted for 12% of Facebook’s revenues in 2011. 23 http://www.huffingtonpost.com/natalie‐pace/facebook‐ipo_b_1251627.html

112-052-1

U s a g e p

e rm

it te

d o

n ly

w it h in

t h e s e p

a ra

m e te

rs o

th e rw

is e c

o n ta

c t in

fo @

th e c a

s e

c e

n tr

e .o

rg

T a u g h t b y A

ri f K

h u rs

h e d , fr

o m

2 -N

o v -2

0 2 0 t o 2

8 -F

e b -2

0 2 1 . O

rd e r

re f F

3 8

6 7

9 9

.

P u rc

h a s e d f o r

u s e o

n t h e F

o u n d a ti o n s o

f F

in a n c e , a t T

h e U

n iv

e rs

it y o

f M

a n c h e s te

r W

o rl d

w id

e L

im it e

d .

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

5

CASE 2012‐14‐C

In its S‐1 Filings24, Facebook acknowledged that over 545 million users had accessed the portal using a mobile device. But, the company has been slow to capitalise on this vital medium. While the company earned $3.2 billion from ads listed on desktop and laptop screens, it has hitherto not identified a credible way to derive similar returns from its users who log in through smartphones and handheld devices. To buy time against these latencies, mitigate threats from competition in the mobile space and uphold the innovative momentum, Facebook has adopted a strategy popular among tech giants in Silicon Valley: acquisitions. Acquisitions by Facebook Over the years, Facebook’s primary competitors have used their vast cash reserves to acquire rival firms and startups that often compete directly with their own technologies and products. Alternatively, firms view acquisitions as a strategy to gain control over a promising new innovation that could provide a synergistic boost to the acquirer’s growth projections25. Facebook has pursued several consolidation‐driven opportunities and made over 30 acquisitions by mid‐2012 (Exhibit 7). Interestingly, the company has merely used cash to finance most of its acquisitions. In some instances, a target was purchased simply to harness the human intellect26. Many recent Facebook acquisitions have been targeted at improving its mobile presence. Just a month prior to the IPO, Facebook purchased Instagram ‐ a mobile app for sharing pictures ‐ for nearly $1 billion in cash and stock. The deal was driven in part by the phenomenal growth in registered users at Instagram27 and was also meant to curb any threats to Facebook’s dominance in the domain of photo sharing. Nevertheless, several critics argued that Facebook had paid an excessive premium for a startup that had no revenues and just 13 employees.

24 A filing with the SEC by public companies to register their securities. 25 Moeller, S., and Brady, C., 2011. Intelligent M&A: Navigating the Mergers and Acquisitions minefield. New York: John Wiley & Sons.

26 Such as engineers, product designers, research scientists etc. 27 Founded in 2010, Instagram had over 30 million users by April 2012.

112-052-1

U s a g e p

e rm

it te

d o

n ly

w it h in

t h e s e p

a ra

m e te

rs o

th e rw

is e c

o n ta

c t in

fo @

th e c a

s e

c e

n tr

e .o

rg

T a u g h t b y A

ri f K

h u rs

h e d , fr

o m

2 -N

o v -2

0 2 0 t o 2

8 -F

e b -2

0 2 1 . O

rd e r

re f F

3 8

6 7

9 9

.

P u rc

h a s e d f o r

u s e o

n t h e F

o u n d a ti o n s o

f F

in a n c e , a t T

h e U

n iv

e rs

it y o

f M

a n c h e s te

r W

o rl d

w id

e L

im it e

d .

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

6

CASE 2012‐14‐C

Controlled Corporation In taking Facebook public, Zuckerberg followed a well‐known technique for maintaining supermajority control. In fact, founders of Groupon, Zynga and many other companies that had an IPO in the recent past have used the same strategy to preserve command over their firms. Zuckerberg has exercised dominance over his board of directors by structuring Facebook under a dual‐class ownership framework. According to Facebook’s S‐1 Filings, the company’s shares are broadly classified into two main classes, which are principally identical except for one key difference. The IPO intends to offer up to 15.5% ownership to the public through its Class A shares (Exhibit 8). On the other hand, Zuckerberg and other key investors hold Class B shares. Each Class A share is entitled to a single vote while every Class B share is equivalent to 10 votes28. Further, a Class B share is convertible anytime to one share of Class A stock at the discretion of the stockholder. Thus, while Zuckerberg owns just 28% of Facebook, his Class B ownership empowers him with a 57.3% share in voting rights29. In other words, Zuckerberg has the power to appoint or dismiss directors and has the final say in all decisions pertaining to the company’s management and strategy. In fact, the decision to purchase Instagram was solely Zuckerberg’s, and the board was not consulted. Under the rules for NASDAQ‐listed companies, Facebook has been designated a ‘Controlled Company’ due to the overwhelming voting power enjoyed by the firm’s Chairman and CEO. In fact, this categorisation neither obliges having a board comprising a majority of independent directors nor does it require the constitution of independent compensation and nominating committees (Exhibit 9). Zuckerberg may also designate a person of his choice to succeed him as CEO. A study in 2011 by CompStudy, an executive compensation research firm, on over 2,500 technology startups revealed that Zuckerberg and his team have performed remarkably well at averting significant dilution vis‐à‐vis industry peers during all venture capital investment rounds. Zuckerberg has succeeded in growing the company’s value much above the industry average. In fact, Facebook was the only company in the sample whose founders held an equity stake in excess of 75% after the third round of venture capital financing. A comparative overview for the first 3 rounds of financing is provided in Table 130:

Table 1: Valuation of Facebook vs. industry peers Financing Round Industry Average Facebook

Capital raised Pre‐Money Valuation

Capital raised Pre‐Money Valuation

Round 1 $3 million $5 million $0.5 million $5 million Round 2 $5.5 million $10 million $12.7 million $100 million Round 3 $7 million $15 million $27.5 million $525 million

28 http://www.webpronews.com/facebook‐ipo‐shares‐to‐be‐divided‐into‐classes‐2012‐05 29 http://www.bankrate.com/financing/investing/facebook‐and‐dual‐share‐classes/ 30 Wasserman, N., 2012. The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup. New York: Kauffman Foundation Series on Innovation and Entrepreneurship.

112-052-1

U s a g e p

e rm

it te

d o

n ly

w it h in

t h e s e p

a ra

m e te

rs o

th e rw

is e c

o n ta

c t in

fo @

th e c a

s e

c e

n tr

e .o

rg

T a u g h t b y A

ri f K

h u rs

h e d , fr

o m

2 -N

o v -2

0 2 0 t o 2

8 -F

e b -2

0 2 1 . O

rd e r

re f F

3 8

6 7

9 9

.

P u rc

h a s e d f o r

u s e o

n t h e F

o u n d a ti o n s o

f F

in a n c e , a t T

h e U

n iv

e rs

it y o

f M

a n c h e s te

r W

o rl d

w id

e L

im it e

d .

E du

ca tio

na l m

at er

ia l s

up pl

ie d

by T

he C

as e

C en

tre C

op yr

ig ht

e nc

od ed

A 76

H M

-J U

J9 K

-P JM

N 9I

O rd

er re

fe re

nc e

F3 86

79 9

7

CASE 2012‐14‐C

Geographical Restrictions and Reduced Business While Facebook is the most prominent social network in the world, there are some gaping holes in its position within certain markets. Most notably, Facebook has been unable to attain a dominant position in Russia and Brazil where other platforms such as vKontakte and Orkut command a wider market share31. In some cases, governments have censored Facebook citing threats to internal security or for having harmed local religious sentiments. Recently, access to Facebook was restricted during the ‘Arab Spring’32 by dictatorial regimes which endeavored to contain the spread of online protests among citizens. The site was also banned temporarily in Saudi Arabia and Pakistan on allegations that it had aided in the propagation of the controversial cartoons on Prophet Mohammad. Facebook is blocked by the great firewall of the Chinese government, which cites the lack of moderation for this decision (Exhibit 10)33. Users can create pages for political campaigns and can criticise anyone without much oversight. The Chinese government is wary that this could help instigate political uprisings over issues like communist rule and Tibet. Competition The social giant has acknowledged stiff competition from rivals like Google and Twitter besides mobile and internet companies whose products have contested with specific features of Facebook. So far, an interconnected user base combined with the release of features like asymmetrical subscriptions have shielded Facebook from the threats posed by Twitter. Google is aware that binding identity together with user activity is crucial for its ad‐ driven business and is working on Google+, a social networking platform, to realize this goal34. Threat to Personal Information Facebook stores users’ personal data which are at risk of being revealed ‐ either at the discretion of the firm or through hacking. In fact, Facebook’s default privacy policy has