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Monday, October 1, 2012

Corporate governance in tech industry. Facebook is dieing.

Features Control Freak The underwhelming stock performance of Facebook Inc. (Nasdaq: FB) since its initial public offering in May is just one of many issues dogging the social media company these days. Founder and CEO Mark Zuckerberg's whopping 57 percent control of the newly public company is another point of controversy. Forced to go public because it had more than the 500 shareholders the Securities and Exchange Commission allows private companies, Facebook formed a board of advisers and sold its shares in the third largest U.S. initial public offering ever, but Zuckerberg still calls all the shots and is able to make decisions with little, or no, input. Zuckerberg's continued control of Facebook is ironic considering that, for the last 15 years, there has been a global movement toward transparency and more shareholder-friendly rules for public companies. With Zuckerberg's majority control, there is little shareholders can do to influence the company's governance or strategy, short of suing. Even if voting shareholders lose control of the majority of the power, the board will then become staggered to give it an extra defense against shareholder takeover. Facebook is not alone. FriendFinder Networks Inc., Groupon, Linkedin Corp. and Zynga Inc. all have structures in place that make it more difficult for activist investors to take control of the board. They either have classified boards, in which board seat elections are staggered, or they have dual-class structures, in which not all shareholders can vote. This is in stark contrast to the trend of more shareholder-friendly boards. According to FactSet SharkRepellent, only 18 percent of S&P 500 companies have classified boards, down from 61 percent in 2002. But, of the 76 companies that went public last year, about 65 percent have classified boards. All of the social networking and new media companies that went public last year had classified boards and/or dual-class structures. Facebook was no different, and there are a growing number of people and firms voicing their concerns over the company's structure. In February, California State Teachers’ Retirement System (CalSTRS), California's $150 billion pension fund that invests on behalf of its pensioners, sent a letter to Zuckerberg, calling for him to increase the size of his board and diversify it. Observers have cited companies, such as Enron and Lehman Brothers, as poster children for what goes wrong when you don't have proper checks and balances. CalSTRS is invested in Facebook through its private equity allocation in two funds and became a holder of common stock when the company went public. Facebook's board has impressive names on it, but is dominated by male venture capitalists and entrepreneurs — people that, naysayers would argue, are just like Zuckerberg. “There's no one that doesn't want complete control around them. Mark has surrounded himself with people that say, ‘Yes, Mark',” says Lucy Marcus, chief executive of Marcus Consulting Ventures, a venture capital consulting firm that frequently works with boards. Marcus is an expert on board creation and board issues. “Having a public company is not about power and control. When you go public, there's a real value in healthy open debate. It's good when you are forced to make your case for something. You need diversity of thought. What Facebook did by keeping the board narrow doesn't make for the strongest company in the long-term,” she says. Although Facebook's corporate structure is irking some, others argue that over the years, some of the most successful companies have been set up to have independence from shareholders’ whims and have done better as a result. The Washington Post, The New York Times, Reader's Digest, Ford Motors, as well as Berkshire Hathaway, were all set up with a dual-class structure, giving Class B shareholders the right to vote. What's more, some believe that having less voter involvement can keep a company nimble, which can be advantageous, especially for a tech company that needs to stay ahead of the curve. In contrast to having autonomy, Yahoo! Inc. has battled with many shareholder groups ever since it went public, creating a big distraction for management. “When you buy stock in a company with this type of structure, you are investing in a small team and putting a lot of faith in a select number of people, because you believe in them. Shareholders can always vote with their feet and walk away,” says Suzanne Hanselman, a member of the securities and corporate governance practice team at Baker Hostetler. She serves as the business group coordinator and business development leader for the firm's Cleveland office. The move to stay as independent as possible from Wall Street influences makes sense for the media companies that opted to have more power over their stock. Additionally, one can argue that Ford has had more success than its Detroit brethren, General Motors and Chrysler, yet it probably had the worst corporate oversight. “Great corporate governance doesn't always equal great financial results,” says Hanselman. “People often believe that more oversight means a better running company, which will bring better results, but that's not always the case.” Despite the outcry for more shareholder say over Facebook, some question how much effort shareholders put into voting in the first place. Proxy statements are often mailed to shareholders who aren't up to speed on the issues and don't vote, but hope that the experts at the helm of the company will make the best possible choices. What's more, in Facebook's case, Zuckerberg is the genius that invented the social networking behemoth. Many shareholders are investing in him and his Facebook concept. “Tech is an industry where the entrepreneurs and founders are so closely associated with the brand. Lots of times, shareholders are putting their money with the founder. In general, many people don't look at their proxy statements and are comfortable voting with management, so long as things are going well,” says Hanselman. Still, there is worry over what Facebook might actually look like in five years, what its business model will be and if it will be a profitable company. Perhaps more input could help shape the company's future, as first-generation users move on. Claire Gruppo, co-founder of investment boutique advisory firm Gruppo, Levey & Co., warns that Zuckerberg better have the foresight to change with the times. Otherwise, Facebook's future will not be so rosy in five years. “The company could be vulnerable. Facebook is about a lot of leisure time. What happens as users grow up and work?” asks Gruppo. “In the last two years, the generation in the mid-to-late 20s are now saying they don't use Facebook anymore. It's becoming your mother's platform, and that makes the younger people hop off. Who's the user going to be? Is Facebook doomed to become Hallmark?” While it's too early to tell what the exact fate of Facebook will be, future tech stock offerings will definitely take a cue from Facebook as to what the public will accept. Had Facebook's stock soared after the IPO, talk of Zuckerberg's control would have been minimal. However, that hasn't been the case. “When a company is doing well, shareholders are much more willing to forgo their rights as to how it is managed,” says Hanselman. In the case of Facebook, shareholders’ only recourse is litigation if there is a breach in responsibility. That said, lawsuits are already popping up. In late May, a lawsuit had been filed against Facebook by disgruntled shareholders who claim that they weren't made privy to the company's revised growth figures. If the company's stock does not rebound, more lawsuits are expected to pop up. “A lawsuit is the only remedy the shareholders have, and there would have to be abuses of power to even bring a lawsuit. Shareholders don't have the ability to vote out management if they don't like how the company is running. When they bought the stock, they effectively agreed to waive any influence in how the company is managed,” says Hanselman. Facebook Taps VC-Backed Startups The social network has bought 25-plus companies over the last four years and is expected to keep on shopping Assuming it recovers from its rather bumpy initial public offering, Facebook Inc. will be well poised to give Google Inc. and other large Internet and media companies a run for their money when it comes to making tech acquisitions. Over the course of four years, Facebook has bought more than 25 companies, with its recent $1 billion splurge on photo-editing developer Instagram, which has about 50 million users, being the largest to date. As the company expands its mobile application offerings, it is likely to add dozens more targets to its shopping basket. Instagram notwithstanding, Facebook has stayed mostly on the path of acquiring small venture-backed technology companies. Bringing aboard the founders of targets has often been the driving force behind the company's purchases. Claire Gruppo, co-founder of investment boutique advisory firm Grup-po, Levey & Co, points out that until now, Facebook's strategy has been to acquire applications, especially ones that it may have trouble developing internally. “They buy relatively small businesses, with dynamite founders, with two- or three-person teams,” says Gruppo, who noted that some of the deals were defensive moves in order to stay ahead of competitors. “If you're as big as Facebook, you better be acquisitive of small cutting-edge technology.” (Visit to view a video interview with Gruppo about Facebook's acquisition strategy and its impact on the rest of the tech sector.) Facebook has been racking up mobile application deals. At the end of its first day of trading, the company sealed another deal and announced that it acquired the mobile commerce startup, Karma. Shortly after the Instagram deal, Facebook snatched up the mobile marketing firm Tagtile. In May, the company continued the shopping binge by buying Lightbox, a photo-sharing application for Android devices and other mobile devices, and Glancee, a social discovery application for mobile devices. After the Instagram deal, Zuckerberg stated that he doesn't plan on making another big acquisition of a product that has “so many users.” The company also explained in its public offering SEC filing that it may not have the ability to acquire and integrate larger or more complex companies, products, or technologies effectively. “In the future, we may not be able to find other suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all,” the company said. While Facebook may not be in the position to handle large acquisitions, it does have a knack of luring talent from up-and-coming technology companies. In 2010, Facebook was among those bidding for mobile location-based startup, Foursquare. As it turns out, the founders and its backers weren't ready to sell. Facebook didn't consider this a loss; instead it sought and acquired a competing check-in service, Hot Potato. Facebook placed Hot Potato founder Justin Shaffer in the position to construct a mobile location function for the company. The next step was to get top talent from Foursquare. Facebook poached Foursquare's software engineer and co-founder Nathan Folkman to help develop the project, which became Facebook's Places. Other startups Facebook has poached talent from include: Spotify Ltd, Daytum, Rdio Inc., and Yelp Inc. (NYSE: YELP). It also hired a designer who worked on Apple Inc's (Nasdaq: AAPL) first set of iPhones and iPads. In addition to Foursquare, the one that got away from Facebook appears to be, at least for the moment, Pinterest, the fast-growing content-sharing site that acts like an online pin-board and has quickly amassed nearly 20 million users. Afterthe Instagram deal, observers wondered if Facebook would make a play for it. On May 17, it was reported that the Palo Alto, Calif.,-based company raised $100 million in a financing round led by Japan's largest e-commerce service company, Rakuten Inc., and U.S. venture capital firms, including Andreessen Horowitz, Bessemer Venture Partners, and FirstMark Capital Partners. The deal valued Pinterest at a staggering $1.5 billion. Meanwhile, Facebook appears to have plenty of money in its war chest to buy what it wants. Prior to its IPO and the purchase of Instagram, the company got an $8 billion loan, when it increased its line of credit to $5 billion from $2.5 billion. The advance also included a 364-day bridge loan of $3 billion. Facebook also raised approximately $6 billion, when it sold its Class A common stock. According to its latest filing with the SEC, a portion of the proceeds may be used for acquisitions. —TAMIKA CODY

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