Wednesday, December 02, 2009

Facebook's Dual Class Shares a Folly

By Eric Jackson, Senior Contributor

12/02/09 - 06:02 AM EST

Stock quotes in this article: YHOO , GOOG , MSFT , WPO , NYT

Facebook announced last week before the Thanksgiving holiday that it has created a dual-class share structure.

If you are an existing shareholder, your shares now have 10 times the voting power of any subsequently issued shares. It's widely viewed as a precursor move to holding an IPO in the next year or two.

Facebook has tried to cloak the announcement in language of "ensuring the company can continue to focus on the long term to build a great business." But, make no mistake, this is a pure power grab by founder Mark Zuckerberg to avoid being accountable, while raising money on the cheap.

Mark Zuckerberg
Mark Zuckerberg, Facebook CEO

Dual-class share structures are good for enriching and entrenching management but bad for public shareholders, as companies using these structures tend to underperform their peers over time.

Mark Zuckerberg is no Jeff Bezos, Larry Ellison or Steve Jobs. He's nowhere close -- for the moment. He's a guy who started a social Web site that wasn't as creepy as MySpace was at the time. It has become the de facto standard for social networking with traffic that almost surpasses Yahoo! (YHOO Quote).

Congratulations to him and the many talented employees there. However, there are many warning signs -- in addition to this new dual-class structure -- about how Zuckerberg runs the company that should give pause to investors considering buying into a future Facebook IPO.

First, there was the legal controversy surrounding the founding of Facebook. Remember the Winkelvoss brothers at Harvard who claimed Zuckerberg had copied their ConnectU site (which they'd hired Zuckerberg to do some work on) back at Harvard?

That claim, after dragging on for year, was settled out of court for $65 million at the time (although that number fluctuates with the current valuation of the company, as it was partly paid in Facebook stock). We'll never really know the truth around what happened back at Harvard, but we do know they had a legitimate claim that they pursued for several years and that it was never dismissed.

More worrisome about the long-term health of the company is that there has been a steady stream of senior executives surrounding Zuckerberg who've exited the company over the past three years. If there were one or two, you could chalk it up to someone's personal situation or "pursuing new opportunities."

When there are 13 departures, it's fair to ask what are they running away from. Co-founders Dustin Moskovitz, Chris Hughes, Andrew McCollum, and Eduardo Saverin; COO Owen Van Natta; CFOs Gideon Yu and Mike Sheridan; Marketing VP Matt Cohler; President Sean Parker; CTO Adam D'Angelo; VP of Product Development Doug Hirsch; VP of Sales Tricia Black; and VP of Engineering TS Ramakrishnan. Mark Zuckerberg is the common denominator.

When a former employee was asked about this, he responded:

Is there a common thread to the ... people leaving? ... One shared sentiment ... is that Mark is a very demanding person to work for; if you screw up, one day you are in, the next day out, persona non grata. Some folks chalk that up to immaturity on Mark's part."

Sheryl Sandberg was brought in from Google (GOOG Quote) to be Facebook's COO in March 2008. At the time, the move was spun as an older, senior executive coming to help the 25-year-old CEO. Yet, it doesn't appear that Zuckerberg's power as CEO or his intention to remain as CEO for the foreseeable future have lessened since Sandberg's arrival.

It is a bit of an awkward position for Sandberg to be in. She's senior, yet she has no real power. In the meantime, she reports to someone 15 years younger. It would make sense if she were promised a deal to get the brass ring at some specified date in the future (and maybe such a deal exists), but it certainly appears that "Zuck" isn't going anywhere for now.

There were some rumors around Sandberg's departure from Google being more about moving away from clashes she had with other executives and less about moving toward a great opportunity. Those rumors have never been substantiated.

The bottom line, though, is that future IPO investors can't rely on Sandberg to protect their interests as long as Zuckerberg stays in charge.

You can argue that Zuckerberg has -- in addition to riding a wave of goodwill and traffic -- also raised significant capital for the company at valuations that were very favorable to him, other founders and his employees.

More than $716 million has been raised by this company over the years -- most recently at a $10 billion valuation for the company. Yet the vast majority of the significant capital recently raised by the company (from Microsoft (MSFT Quote), Li Ka Shing and DST) was raised by Owen Van Natta and Gideon Yu -- not Zuckerberg. Both men have since left the company. Let's see how Zuckerberg does on the IPO roadshow, standing on his own two flip-flops.

Now we have the latest move, to a dual-class share structure. Google is probably the most successful company that also famously has such a structure -- which it put in place before its IPO. Google's success now provides Facebook cover on this issue.

In my view, dual-class structures are inherently wrong -- no matter which company you are. No companies succeed because of a dual-class structure that lets the founders sit in their offices and daydream out the window about the long-term possibilities for their company; any company (including Google) that succeeds with such a structure does so in spite of it.

Dual-class structures are inherently antishareholder. They are favored by family monarchs who usually run media companies or monopolistic cable companies. How's that focus on long-term value creation working out for The Washington Post (WPO Quote) and The New York Times(NYT Quote)?

Recent academic studies have shown managers at dual-class structure companies waste cash-flow and pursue goals that serve their private interests vs. those of shareholders compared to non-dual-class structures.

The fact that some very prominent venture capitalists (Greylock and Accel Partners) on this board are allowing this to go on is an embarrassment to them. Silicon Valley VCs have a practice applying laissez-faire corporate governance -- especially to perceived "rock star" entrepreneurs who can't shave yet. This hands-off approach to not "rocking the boat" with the successful founders would make even East Coast crony capitalist banker directors blush.

If Zuckerberg wants to retain supreme control of the company he started (Winklevoss brothers notwithstanding), he shouldn't take Facebook public or take public shareholders' money. Stay private. Rule your fiefdom as a private company in any manner you see fit. That's your investors' problem.

Or perhaps Zuckerberg should go to his existing investors (like Jim Breyer, Peter Thiel, David Sze and Li Ka Shing) and tell them that his shares are going to have 10 times the voting power as theirs "for corporate governance reasons." Let's see how they would react to that.

It's time for investors to start avoiding companies that take on dual-class structures. And it's time for Zuckerberg and Facebook to grow up.

Google co-founders Sergey Brin and Larry Page, as well as Yahoo! co-founders Jerry Yang and David Filo, had the good sense to step aside as leaders early on for the greater good of their companies. Zuckerberg suffers major delusions of grandeur and won't stop, even if it kills the company. Until that changes, private and public investors should steer clear.

At the time of publication, Jackson's fund held a long position in MSFT.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

Sphere: Related Content
blog comments powered by Disqus