McKenna Featured in Wired

Tim Carmody, a staff writer at Wired, called and asked for my thoughts on the Facebook S-1, their IPO filing with the SEC dated February 1, 2012.

Carmody, I think, expected me to have some criticisms about Facebook’s accounting. After all…

so much depends


being more


connected with

the world

don’t be chicken


Most initial news accounts of the Facebook S-1 focused on CEO Mark Zuckerberg’s Stalinist-like stranglehold on the stock, the strategy, and the board. Carmody waited a few weeks to file his story, after recording an hour of our conversation on the phone a few Saturday afternoons ago, and got lucky. Apple announced some significant to changes in their corporate governance that contrast sharply with Facebook and Zuckerberg’s one-man band approach.

Apple has bowed to investor demands to give shareholders greater influence over the election of directors, a move that will make it far harder for other leading US companies to ignore calls to improve corporate governance standards.
The technology group had disregarded a shareholder vote at last year’s annual meeting calling for the change, but faced renewed pressure from Calpers, the largest US public pension fund, to introduce majority voting for seats in the boardroom at its Thursday meeting…Calpers’ push for change at one of the fastest growing and most popular US companies had become the centrepiece of a campaign for boardroom accountability. Its victory reflects a growing investor consensus in favour of the corporate governance agenda.

Facebook, on the other hand, is a “controlled company.”

Carmody explains:

  • Between his own stock holdings and agreements with early investors including DST Global Ltd and Accel Partners, CEO/founder Mark Zuckerberg controls a majority interest in the company. This gives him total control over approving the board of directors as well as any acquisition or mergers. He also has the ability to appoint his own successor, even after his death.
  • Because of Zuckerberg’s control, Facebook qualifies as a “controlled company,” meaning that it is not required to have a majority of independent directors or a separate nominating committee. Zuckerberg effectively has the ability to select anyone he chooses inside or outside Facebook to serve on the board, and then use his controlling interest to approve his own choices.
  • Facebook has two-tiered stock; private Class B shareholders hold ten times the voting power per share accorded to publicly-traded Class A stock. If Class B shareholders ever lose a controlling interest in the company, the governance structure shifts again; only the board of directors will be able to fill vacancies within its own body, director elections will become staggered (making it even more difficult to vote in an all-new-board), and it will take a supermajority vote to change the company’s by-laws.

Anyone who invests in Facebook under these terms is basically putting their money into a blind trust. They have no say over strategy, over the board – not that shareholders have much influence over the Board of Directors anyway but we can pretend – and there is no dividend. One can only hope for capital appreciation. Like Berkshire Hathaway. Except unlike Warren Buffett, Mark Zuckerberg is probably not kicking the bucket any time soon.

It doesn’t make a hill of beans what the accounting looks like. Investors in the social media/social gaming IPOs are looking for the “pop”, the short term price rise, or medium terms share price appreciation that makes them all smug and satisfied about getting in on a good thing. And in the long term we’re all dead.

What’s really changed from more than a year ago when the private placement by Goldman Sachs fell apart other than we now know Ernst & Young has been with them for a while as auditor and IPO guide? Not much.

So let’s summarize Facebook’s strategy of being a private public company from the perspective of the investor:

  • Facebook limits access to their financial information.
  • Goldman will manage the SPV used to market “shares” of Facebook to outside investors. Goldman has access to Facebook’s books but your access is through Goldman.
  • Facebook likes to say they have $2 billion in revenues but who is testing the quality and veracity of those revenues?  Advertising revenue is one thing – although notoriously easily manipulated from an accounting perspective as we saw in the Time-Warner case.  But “transaction revenue” from equally opaque companies such as Zynga is like cotton candy – potentially all fluff.
  • Facebook’s CEO wants absolute control of the company so he can “realize his vision.”
  • Facebook thinks regulatory control over the securities markets, accounting requirements that protect investors, and legal compliance with these laws and regulations is a “distraction.”
  • Facebook’s CFO is not an accountant, not a CPA and has no public accounting experience. What’s wrong with that? It may be barely tolerable when a company is in startup mode, but this is a big global company that has to be run, run well, and run according to GAAP.
  • Facebook has no requirement to have independent directors on its board who protect the interests and rights of this growing class of outside investors.  Oh, wait… Goldman Sachs can look out for them.
  • Facebook has no requirement to be audited as long as it’s a private public company. It’s notoriously difficult for outsiders to find out who their service providers are – the audit firm or consultant that’s currently reviewing financial and IT controls over the production of financial reporting for investors. Given the amount of outside investment, I’m sure one of the largest global audit firms is advising them. But their reports, and any concerns they may have about controls or corporate governance, are not public nor do they go to the SEC. Facebook is not subject to Sarbanes-Oxley including whistleblower and CEO/CFO certification requirements. Given estimates of Facebook’s “valuation” and expected market capitalization post-IPO, isn’t it a good idea to make sure they’re ready for prime-time?

In the S-1, Zuckerberg describes the “unique culture and management approach” of Facebook as “The Hacker Way.”

I don’t know about you, but I’m skeptical of this approach as it applies to finance, accounting, corporate governance, and internal controls.

But that’s not what this company or its board is focused on.

Carmody quotes me:

“Their audit committee chairman, Erskine Bowles, is a politician,” McKenna added. “That tells you a lot about how they plan to resolve any differences in opinion” with the SEC, IRS or other investigative bodies.

Many others were critical of the board composition. There are no women and, gee, think about all those women playing Farmville and Mafia Wars and sharing recipes, photos of their kids and complaints about their husbands, and passing along news from their high school reunions.

Carmody quotes me again:

“Notice I didn’t say anything about how there are no women on the board,” McKenna told Wired. “I’d much rather have another guy with real financial knowledge than a token woman.”

There’s more, including my comments about Facebook’s auditor Ernst & Young. Please read the rest of Tim’s excellent piece at Wired, “Apple Gives Shareholders More Input; Will Facebook Get the Message?”

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  1. […] “controlled company” status under the New York Stock Exchange listing standards. Just like Facebook where Mark Zuckerberg owns more than 50% of outstanding shares and has also made this election, this means you may be the company President […]

  2. […] voting power for the election of directors is held by an individual, a group or another company. Facebook is the only one of the recent social start-ups to elect this exemption from some key corporate governance […]

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