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Facebook's IPO: A cautionary tale for the company

CNET looks at past high-flying technology IPOs and how they've fared. Hint: Not so great.

Mark Zuckerberg could learn from the mistakes of past high-profile tech IPOs. James Martin/CNET

Over the last several years since Facebook grew out of a college-focused idea into the hang-out spot for the world, the company's growth has exploded. It now has 901 million active users, making it the world's largest social network. And with $1.06 billion in revenue during the first quarter alone, it's quickly becoming a financial giant as well.

But even a massive IPO and a ton of hype isn't enough to ensure long-term success. Sure, analysts expect the company to grow, but its domination of the tech world is by no means assured. In fact, looking at past high-flying Internet IPOs, courtesy of a list compiled by Renaissance Capital, the odds are actually against Zuck and his backers -- not to mention anyone who buys into the Facebook IPO once it's launched.

Out of the top ten Web IPOs of all time, only Google can be called a success. The other nine companies -- including recent (if temporary) darlings Zynga and Groupon -- have seen major drops in share price. Some have shut down completely.

Facebook is currently targeting an IPO price range of $34 to $38 per share that could push its valuation over $100 billion. If it wants to avoid the same fate as 9 of its 10 predecessors, it needs to heed the following lessons.

The Great Brain Drain
Like so many other Silicon Valley startups, Facebook initially didn't have the means to pay employees big cash salaries. Instead, the company offered them stock options and smaller salaries.

Options, of course, are always a risk for employees, who have to hope that deferring compensation this way will pay off once their company goes public. For startups, though, options are a great deal -- a cheap way to attract talent and keep employees working hard.

Once an IPO comes around, all bets are off. Employees who once accepted below-market wages start figuring focusing how much they can make from their options following the stock offering. And companies that handed out too many shares -- or that have merely seen their market value soar -- can expect to lose at least some of those workers.

After Google went public in 2004 with a $1.66 billion IPO -- the the time, the largest for a Web company -- about 900 employees became instant millionaires, including a chef and a masseuse. Within four years, nearly a third of its first 500 employees had left for new ventures. Over the last few years, even more pre-IPO employees have left the company with boatloads of cash in their bank accounts.

A similar scenario could play out for Facebook. Back in December, Reuters reported that Facebook, which had 3,539 full-time employees at the end of March, had issued company shares like crazy over the years, and could create well over 1,000 millionaires when it goes public.

At some point, Facebook realized that it could have a Google-like issue on its hands, and started to cut down on the number of shares offered to employees. But it may have been too late.

For Google, losing so many employees didn't become a major problem, thanks to its highly touted employee-retention initiatives and morale builders -- not to mention the fact that it had the cash to pay big money for good talent.

Facebook will have the same cash to attract talent, but whether it'll handle the brain drain as well as its predecessors have remains to be seen. Facebook itself has acknowledged this could be a problem:

As we mature, the incentives to attract, retain, and motivate employees provided by our equity awards or by future arrangements, such as through cash bonuses, may not be as effective as in the past. Additionally, we have a number of current employees whose equity ownership in our company gives them a substantial amount of personal wealth. Likewise, we have a number of current employees whose equity awards are fully vested and shortly after the completion of our initial public offering will be entitled to receive substantial amounts of our capital stock.

As a result, it may be difficult for us to continue to retain and motivate these employees, and this wealth could affect their decisions about whether or not they continue to work for us.

Beware the lock-up
A second challenge awaits down the road, when a mandatory lockout period expires, allowing employees and certain other investors to begin selling off their shares. If too many people sell too much stock at once -- well, say goodbye to the share price.

Facebook is offering, at most, 484 million shares of class A common stock at its IPO -- a relatively small number, as these things go. The company acknowledged in its SEC filing that out of the 635.9 million class A common stock units that will be outstanding after its IPO, 214.6 million will be available for sale "in the near future," potentially causing a substantial decline in the stock price.

"Substantial blocks of our total outstanding shares may be sold into the market when 'lock-up' or 'market standoff' periods end," the company wrote in its SEC filing. "If there are substantial sales of shares of our common stock, the price of our Class A common stock could decline."

Zynga's executive team was all smiles on IPO day -- just months before launching a secondary offering.
Zynga's executive team was all smiles on IPO day -- just months before launching a secondary offering. Zynga

To limit the effects of a post-lockup selloff, some companies hold a secondary stock offering in which their employees can sell their locked-up shares to underwriters -- essentially keeping them off the open market, and thus preventing a sudden shock to the share price.

A similar issue played out with both Zynga and LinkedIn. After going public, and just prior to their lock-up period ending, the companies were forced to issue a secondary offering of shares to increase their float and limit the impact of a massive sell-off by investors.

That said, it's not immediately clear if Facebook will need to issue a secondary offering. In many cases, companies offer enough shares to limit the impact any major selloff might have. In others, the companies expect a more staggered approach to sales that will limit any hit to shares.

Even so, it appears it's something Facebook is concerned about -- and something shareholders should keep in mind over the next few months. Because if it miscalculates -- say, by not holding a secondary offering when it should have -- the consequences for shareholders could be dire.

Zuckerberg's Power
For Mark Zuckerberg, much of his time at Facebook has been spent holding purse strings and steering the company he co-founded in the direction he desires. And even though his company is now going public, it's clear that he has no desire to give that up.

According to Facebook's S-1, Zuckerberg will control the voting rights of nearly 900 million shares of common stock, giving him 55.8 percent control of the company's shares. That, Facebook says, affords him the exclusive right to make all decisions related to board of director appointments, mergers, consolidations, and sales of the company's assets.

Facebook co-founder Mark Zuckerberg.
Facebook co-founder Mark Zuckerberg. James Martin/CNET

"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," the company writes in a filing.

Whether that's an issue, of course, remains to be seen. Back in 2004, when Google went public, the company's use of a dual-class stock system, similar to what Facebook has employed, gave co-founders Larry Page and Sergey Brin the same sort of control. In his own company's S-1 statement, Page warned investors that "by investing in Google, you are placing an unusual long-term bet on the team, especially Sergey and me."

And yet, Google has fared well since that IPO as its revenue continues to soar and shareholders jump at the chance to invest in the company's stock. In the last five years alone, Google's shares are up 31 percent to $628.16. Google kicked off its IPO at $85.

The focus now, for Facebook and Zuckerberg, is to harness that control and continue to make sound decisions. However, Zuckerberg didn't make any friends last month when he reportedly decided to go it alone with a $1 billion Instagram purchase, and only informed the board when the deal was all but done.

Should one person -- even though he's the co-founder and leader -- be able to single-handedly make a $1 billion decision? That's for shareholders to decide.

Life beyond the IPO
Although much will stay the same post-IPO, Facebook will have to deal with one major change: many more owners who won't take too kindly to down quarters, mistakes in acquiring new companies, or misguided strategies. Facebook, for the first time, will need to answer to a group of investors that might not be as forgiving as its current owners.

The only way for shareholders to respond to issues they have with a company is to sell their shares. And based on a list compiled by Renaissance Capital of the top 10 Web IPOs of all time, just because a company posts a major offering, it doesn't ensure future success.

For example, there's always a chance that Facebook could watch its shares plummet nearly 43 percent the way Yandex's have in the last year since it's been on the NASDAQ. And despite all of the excitement surrounding Groupon's $700 million IPO last year, that company, which comes in eighth place for the top Web IPOs of all time, has watched its shares drop 53 percent since its initial offering. Shanda Games and Giant Interactive Group, two China-based online-game developers, have watched their shares plummet 58 percent and 73 percent, respectively, since they went public.

IPO investment adviser Renaissance Capital

As noted, out of all 10 companies in the Renaissance Capital listing of biggest Web IPOs, just one -- Google -- has watched its shares rise over their initial offering price.

So, what will the future hold for Facebook? Will the company join the many other top Web IPOs and watch its shares sink over time, or will it buck that trend the way Google did? Most analysts at this point have their money on the latter course, with Sterne Agee analyst Arvind Bhatia saying recently that the company's shares are an outright buy over the next 12 months.

But in the world of IPOs, nothing is set in stone. And gambles are taken on both sides of the fence as investors and companies hope that their mutual relationship will benefit them. Now it's Facebook's turn to take that gamble. Will you respond in kind?

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