What Is Facebook Afraid Of?

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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 (Nasdaq: GOOG  ) or Yahoo! (Nasdaq: 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 (Nasdaq: 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 (Nasdaq: 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 (Nasdaq: 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.

This is not the kind of leadership that makes me want to invest. In a brand-new special report, our finest analysts present some of the finest management teams on the planet. These are stocks any Fool would be proud to own. It's free to access "3 Stocks That Will Help You Retire Rich," but only for a limited time, so get yours today.

Fool contributor Anders Bylund owns 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 services have 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 services free 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 out Anders' holdings and bio, or follow him on Twitter and Google+. We have a disclosure policy.

Read/Post Comments (10) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 04, 2012, at 10:40 PM, applefan1 wrote:

    Well, they left out copyright infringement. They are now allowing people to post and sell through their Facebook interface music that people have produced and have distributed through CD Baby. Well, I'll let you in on a little secret. CD Baby does not operate like a big record label/distributor like Sony, Universal, etc. The big major players won't talk to a local band, artist or independant music labels unless they have LEGAL representation. If they don't have LEGAL representation, then they pretty can kiss goodbye LEGAL contracts. Without LEGAL contracts, then the website, distributor, record label are probably engaging in copyright infringement, Some people know about this, but most don't. I know of several local artists that don't have legal congracts with the musician's on their so-called self produced CDs and they are getting away with selling it and having it produced.

    is Facebook held iiable? if they are selling the content with their services, yes, they are held liable. how much? Well, it goes fromm $750 to $30,000 to $150,000 per violation. So let's say a CD with 10 songs has 3 musicians on it and no LEGAL contracts are in place and they don't pull the content within 14 days of being notified, to each musician they can get upwards of $159,000 per song per musician. Obviously, it is less if they pull within 14 days, but still do the math. how many local artists and bands don't have all of the required contracts and release forms signed with a proper attorney involved? a lot more than anyone wants to admit. Facebook is open to being sued for copyright infringement because they don't check or require people to have legal representation and proof before the content is posted, It is basically a free for all.

  • Report this Comment On February 05, 2012, at 12:58 PM, dwilh51183 wrote:

    Facebook's Mark Zuckerberg is planning on buying a 30% stake in Apple ( AAPL ). Sources close to Facebook say he's negotiating with banks to do the deal .

  • Report this Comment On February 05, 2012, at 1:10 PM, applefan1 wrote:

    Well, if he does, then Apple's stoc wil spike. I guess he is hedging his bets.

  • Report this Comment On February 05, 2012, at 1:13 PM, applefan1 wrote:

    Is that speculation or is there any real proof?

  • Report this Comment On February 05, 2012, at 1:35 PM, ETFsRule wrote:

    That's crazy. Even Zuckerberg can't come up with $128 billion. Are you sure it's not a 3% stake he's looking to buy?

  • Report this Comment On February 05, 2012, at 1:37 PM, ETFsRule wrote:

    That would be what, $128 billion? Maybe it's 3% not 30%.

  • Report this Comment On February 05, 2012, at 1:37 PM, ETFsRule wrote:

    Stupid double post.

  • Report this Comment On February 06, 2012, at 1:45 PM, R2Big wrote:

    Despite frequent criticism, Mark Zuckerberg has done a great job guiding Facebook into becoming a big business and has made solid long-term focused decisions. Looking at the market, I see very little that could actually take down Facebook. I actually see Facebook as a much bigger threat to Google than anything else out there over the long term as Facebook grows to other markets like search.

  • Report this Comment On February 08, 2012, at 4:00 PM, H0MBRE wrote:

    Soon enough Facebook users will cave and switch to other social networks. There is growing resentment against the site for a handful of reasons. Adding insult to injury, Facebook stock will not be offered at discounted rates to long-time users; users make the money for Facebook with the click of their mouse. Everyone is increasingly aware of this.

  • Report this Comment On February 11, 2012, at 11:04 PM, ETFsRule wrote:

    "Adding insult to injury, Facebook stock will not be offered at discounted rates to long-time users..."

    Please tell me this was intended as some kind of satire.

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