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Facebook Fought SEC to Keep Mobile Risks Hidden Before IPO Crash -...

Facebook Fought SEC to Keep Mobile Risks Hidden Before IPO Crash

When Facebook Inc. (FB) filed its proposal Feb. 1 to go public, it touted the effectiveness of ads linked to customers' friends, citing research from Nielsen, the audience-counting company.

Barbara Jacobs, an assistant director for corporation finance at the U.S. Securities and Exchange Commission, was skeptical, as she and her staff vetted the filing to ensure Facebook had disclosed all material information to investors. The claim appeared to be drawn from marketing materials, not a Nielsen study, she wrote to Chief Financial Officer David Ebersman, 42.

She gave him an ultimatum: Produce the study and provide Nielsen's consent for use of the data -- or don't use it, she wrote to Ebersman on Feb. 28. Facebook dropped the reference after initial resistance.

The incident was part of a two-and-a-half-month volley of messages among SEC officials, Ebersman and Facebook's law firm Fenwick & West LLP. A dozen letters, published a month after the May 17 IPO on the SEC's website, depict a management team hesitant to disclose information and still guessing at even rudimentary aspects of its business just weeks before the company held the largest-ever technology initial public offering. Many of the issues raised by the SEC and now unnerving investors were foreshadowed in the then-private correspondence between the SEC and Facebook.

"They were given the benefit of the doubt when they went public that they were ready for prime time," said Michael Pachter, a managing director at Wedbush Securities Inc. "They still haven't proved that they are."

Mobile Users

On the most critical issue facing Facebook's future as a public company -- whether it could make money from the soaring number of mobile users, who see fewer ads than other customers - - the letters show executives holding back crucial details until the SEC pushed for further disclosure.

Noting that Facebook was counting some mobile users twice, Jacobs wrote on March 22: "Please explain to us how you determined that your metrics are not overstated."

Only eight days before the IPO, on May 9, did Facebook make clear in a filing that that daily mobile customers were increasing faster than advertising growth, potentially hurting revenue and profits. It was the strongest public signal that the IPO could fall short of its high expectations.

The issue of mobile users is even more relevant today as Facebook, based in Menlo Park, California, announced on Oct. 4 it now counted one billion users worldwide, up from 845 million at the year's start. More than half of them, or 600 million, access Facebook through a mobile device, a number that grew 41 percent this year.

‘Increasingly Skeptical'

"We've been growing increasingly skeptical of some of their monetization methods," Richard Greenfield, an analyst at BTIG Research, told Bloomberg Television on Oct. 8, referring to Facebook's struggles to get revenue from mobile users. He cut his rating on the shares to sell.

Facebook went forward pricing the IPO at $38 a share. That was 107 times trailing 12-month earnings, making it more expensive than 99 percent of all companies in the Standard & Poor's 500 Index at the time. The SEC has no say in setting IPO prices.

Once called the IPO of the century, Facebook has dropped 45 percent through Oct. 5. That's the worst offer-to-date performance of any U.S. IPO raising at least $1.5 billion since 2007, when MF Global Holdings Ltd. (MFGLQ) went public, according to data compiled by Bloomberg.

Ashley Zandy, a spokeswoman for Facebook, declined to comment for this story.

Retail Investors

The losses were acute for retail investors. They were allocated an unusually high proportion of shares after institutional investors balked. And they didn't get the same flurry of warning calls from Facebook officials who, days before the IPO, privately advised securities firm analysts to lower earnings and profit estimates -- largely on the dearth of revenue from mobile users.

"It has been clear from the beginning that the insiders were bailing given that they sold $10 billion of shares and continued to sell as the lock-up period expired," said Francis Gaskins, president of, an independent IPO research firm in Marina del Rey, California. "They clearly knew that the company's best growth rate was behind them and the stock was overvalued."

By the time the final amended prospectus was filed May 16, a day before the company went public, Facebook had over the weeks included the mobile data and many of the material facts the SEC had demanded.

SEC Correspondence

What investors didn't see until a month after the IPO were the letters that pushed Facebook to disclose in detail such key financial challenges as decelerating revenue growth, user count and its dependence on gaming company Zynga Inc. (ZNGA) -- all issues that arose in prominence after it became a public company.

Publishing the SEC letters beforehand would be "a better way to get the information to the market than an amended filing," said Peter Henning, a former SEC lawyer who teaches at Wayne State University in Detroit. "The SEC is a better soap box than the filings."

Even a summary of points would be helpful for investors, Henning said, should the SEC decide that disclosing the letters would exert undue influence over market sentiment.

"As an investor you want all the information you can get, and that would certainly be one of the pieces," money manager Michael Holland, chairman of Holland & Co., said of the correspondence. He chose not to buy Facebook at the IPO because it was more expensive than Apple Inc. and Google (GOOG) Inc., he said.

‘Complete Picture'

Current SEC policy is to release correspondence no earlier than 20 business days after the IPO. The SEC doesn't post correspondence "real time," said John Nester, a spokesman, because "people could misinterpret our questions to companies about their disclosure before companies have had opportunities to provide a complete picture." By law, "a company is responsible for its own disclosures," he said.

Luigi Zingales, a finance professor at the University of Chicago's Booth School of Business, said Facebook should have delayed the IPO after it cut its forecasts. Analysts said the late revisions were surprising and almost unprecedented.

"When you have a significant change in your forecasts it's good business practice to postpone the IPO so that the market has more time to understand what's going on," Zingales said.

By the time the letters were published, the stock was cratering, on the way to losing half its $38 IPO price and erasing as much as $49 billion in market capitalization. The stock that sold for $16 billion in the IPO was worth $8.6 billion as of Oct. 8, data compiled by Bloomberg show.

Month's Salary

Ryan Cefalu, a 34-year-old data-systems manager and father of two in Baton Rouge, Louisiana, said he bought about $4,000, or about a month's salary, in Facebook stock and has lost about $2,050 on paper.

"The IPO went terribly," he said. "I expected it to go up for a couple days at least before it went it down. That never happened. It never had a chance to."

The SEC continues to investigate Facebook's IPO to determine whether any material information was omitted or misrepresented. The SEC is conducting an "in-depth review of all the participants" in the IPO, SEC Chairman Mary Schapiro said in an interview that aired Sept. 28 on Bloomberg Television. She declined to elaborate.

The Senate Banking Committee is also looking into the matter, and has held meetings "with a range of involved parties including Facebook, Nasdaq, Morgan Stanley (MS), and the SEC," said Sam Gilford, press secretary for the Senate committee, in an e- mailed statement.

Legendary Transformation

Facebook's eight-year transformation into the largest social-networking service is the stuff of legend. Born of marathon late-night coding sessions by Mark Zuckerberg and his Harvard University schoolmates, Facebook swiftly expanded beyond being a site for college kids into a network linking people from across the country, and eventually, the globe.

An IPO loomed as the investor base widened, reflecting insiders' desire to sell. It was also spurred by SEC financial disclosure requirements for companies that have more than 500 shareholders. All the while, the public caught glimpses of Facebook's potential valuation from high-profile private investments -- like Microsoft Corp. (MSFT)'s purchase of a 1.6 percent stake, which gave Facebook a $15 billion valuation, or a $1.5 billion private placement managed by Goldman Sachs (GS) Group Inc. valuing Facebook at $50 billion.

Stock ‘Hysteria'

Facebook trading on secondary market-maker SecondMarket Inc. suggested a market cap of $85 billion in July 2011, seven months before Facebook disclosed on Feb. 1 that it planned a share sale.

"Before the underwriters were even selected, hysteria about this stock was already out of control," Erik Gordon, a professor at the University of Michigan's Ross School of Business, said in a phone interview.

It's not unusual for a company going public to tussle with the SEC over what should be included in its prospectus. Yet Jacobs's inquiries underscored growing concern within the SEC over the way newer consumer Web companies account for increasingly large user bases, according to a person with knowledge of the matter.

The regulator is spending more time scouring user-growth metrics and requiring more details, said this person, who asked not to be named because the SEC's review process is confidential.

Jacobs's Team

Last year the agency pressed Groupon Inc. (GRPN) to abandon an accounting method that made the then-unprofitable daily coupon business look profitable by hiding certain marketing costs, a person familiar with the matter said at the time. Julie Mossler, a spokeswoman for Chicago-based Groupon, declined to comment.

The official whose name became most closely associated with the prodding of Facebook is the SEC's Jacobs, whose eight-person information technologies and services team at the SEC's Disclosure Operations Office was tasked with reviewing the Facebook filings that began Feb. 1.

Jacobs, who is 51 in public records, has held various roles at the SEC since 1989, once proposing rules to let small companies price securities on a delayed basis, according to her profile on the Practising Law Institute's website. She holds law degrees from the University of San Francisco and Georgetown Law Center.

Her letters were addressed to Ebersman, who joined Facebook as chief financial officer in 2009 after holding the same title at drugmaker Genentech Inc. from 2005 until early 2009. A graduate of Brown University with a degree in economics and international relations, Ebersman replaced Gideon Yu, who left after Facebook said it wanted a successor with experience in running a public company.

Zynga Questions

Facebook's responses were signed by Jeffrey Vetter, 46, of the Mountain View, California, law firm Fenwick & West. He declined to comment. Vetter, who joined Fenwick in 1995, has also helped prepare public offerings for companies including Fusion-io Inc. and Jive Software Inc.

By the end of February, the SEC had amassed a list of 92 matters on which it sought further information.

An area of concern: Facebook's reliance on Zynga, which makes the five most popular games played on Facebook including "Texas HoldEm Poker." When Zynga missed earnings estimates in July, Facebook's stock tumbled 8.5 percent, underscoring their interdependence.

At first Facebook's filing said Zynga accounted for 12 percent of 2011 revenue. After further prodding, Vetter said that Facebook last year got 19 percent of revenue from Zynga - -12 percent from processing fees of virtual goods and 7 percent from ads on pages generated by Zynga apps.

Rival Services

The SEC also got Facebook to include a warning that Zynga, which had recently begun offering games on its own and other websites, could lure Facebook users away, hurting Facebook financially.

"Zynga may choose to try to migrate users from existing Facebook-integrated games to other websites or platforms," Facebook disclosed. As a result, "Our financial results may be adversely affected," it said.

Concerns related to Zynga drove JPMorgan Chase & Co. (JPM) and Morgan Stanley to cut their price targets for Facebook last week. They cited lower expectations for revenue from Facebook's payments business after Zynga reduced forecasts.

Dani Dudeck, a spokeswoman for Zynga, declined to comment.

Revenue Details

Jacobs also asked Facebook why it hadn't included data on revenue generated by each user, a "key" indicator of performance. Vetter dismissed the request on March 7, saying that the company prefers to look at "overall growth in users" and "overall revenue in evaluating the business."

Unswayed, the SEC carried out revenue-per-user calculations itself, which Facebook only then included in a revised filing on April 23.

The figures showed revenue worldwide from each monthly active user declining, to $1.21 in the first quarter from $1.38 in the fourth, a seasonal drop, according to Facebook. They also revealed that per-user revenue was lower in Asia, at just 53 cents down from 56 cents in the fourth quarter.

One of the most contentious issues was Facebook's halting disclosure of the number and growth of mobile users of Facebook, where they were located, and how it would derive revenue from them.

In its initial filing, known as an S-1, the company said mobile usage of Facebook increased around the world and numbered 425 million "monthly active users" in December 2011. It acknowledged that it hadn't proven it could "monetize" people using only mobile devices, where the absence of ads may "negatively affect our revenue and financial results."

‘Excessive Expenses'

Jacobs responded on Feb. 28 by asking for a "more detailed" discussion of these key challenges. If the company's attempts to monetize those mobile users fail, she wrote, then "ensure" that your disclosure addresses the potential consequences to revenue, "rather than just stating that they ‘may be negatively affected.'"

Vetter filed a revised prospectus on March 7, disclosing that Facebook's monetization strategy could run up "excessive expenses."

Still, in a letter the same day he resisted Jacobs's effort to reveal the number of users who "primarily access" Facebook through mobile devices, saying they didn't have a "reliable" count.

Facebook would disclose the number of daily active mobile users only "for the staff's reference," not in its registration statement, Vetter wrote. That number showed a big jump, to an estimated 58 million mobile-only Facebook users on Dec. 31, 2011, from 23 million on March 31, 2010.


Jacobs asked for the impact on revenue of greater mobile use, only to be told by Vetter that Facebook couldn't "specifically assess the impact" as those users may also be using personal computers to get onto Facebook. When asked how many new users were mobile only, he estimated that 69 million, or 44 percent, of the 156 million new users might be mobile- only.

Asked about the geographical breakdown of mobile users, Vetter said it didn't have a reliable count. For instance, he said, the company counted as Canadian many BlackBerry (RIMM) users around the world because the servers are based in Canada.

This prompted Jacobs to question whether Facebook's then- overall user count of 845 million might be wrong as a result of the fuzzy number of mobile users.

Facebook said it believed its data were "reasonably accurate" as overall data eliminated the multiple counting of mobile users.

Ad Disclosure

On May 9, Facebook released a disclosure to investors cautioning about the growth in mobile users exceeding growth of ads. It was a pivotal admission -- and one of the first warnings that drew widespread attention from analysts and investors.

On that same day, Zuckerberg, Ebersman and Chief Operating Officer Sheryl Sandberg were in the midst of the road show to pitch the stock to investors.

Investor relations staff at Facebook began placing a battery of calls to equity analysts with a dour warning: sales for the second quarter and full year wouldn't likely match its earlier guidance, according to people familiar with the situation.

Analysts adjusted their forecasts down and shared them verbally with their firms' institutional clients, whose demand for the stock sagged as a result, people with knowledge of the matter said on May 10. Sharing that information only with institutions isn't unusual, and it's legal as long as they don't do it in writing.

Market ‘Mistrust'

Still, said finance professor Zingales, "The fact that some institutional investors got access to a company's information that was not available to ordinary investors creates the perception that there are two sets of rules and increases the mistrust in the market."

Despite the cautionary signs, on May 15 Facebook and Morgan Stanley executives raised the asking price to a range of $34 to $38 from $28 to $35. A day later they also increased the number of shares being sold by 25 percent to 421.2 million. That was an effort to create a stronger buffer against a price decline in August when insiders and early investors were allowed to sell their stock, said one person familiar with the matter. The lock- up period was for only three months, unusually short compared to the average six months.

Pricing Decision

The final pricing decision was worked out in a May 17 conference call joined by the highest ranks of Facebook and lead underwriter Morgan Stanley. On the call were Ebersman, Michael Grimes, Morgan Stanley's global co-head of its technology investment banking group, and Morgan Stanley CEO James Gorman, an unusual appearance by an investment bank's chief that reflected the importance it ascribed to the IPO, people familiar with the matter said May 23. JPMorgan and Goldman Sachs executives joined in too.

They reached consensus on pricing the IPO at the top of the $34 to $38 range, as a lower level would have signaled weakness in demand, said one of the people close to the situation.

Contention also arose over the volume of shares that should be set aside for retail customers. Facebook went into the road show with the intention of shifting more shares than usual to retail investors, according to the same person. Goldman Sachs, one of the banks in the IPO, pushed back against the idea, arguing that it was hard to gauge retail demand and that those investors tend to sell quickly at the first sign of a stock's volatility, the person said.

Including Users

Yet Facebook wanted the larger retail allocation to let its users take part in the IPO, the person said. In the end, 25 percent of the shares sold at the IPO were allocated to retail investors, other people have said. That exceeds the average amount of 15 percent.

On the first day the lock-UNNps expired, Aug. 16, Facebook declined 6.3 percent to $19.87. Those shares freed up made up only 14 percent of the total 1.91 billion that will eventually be unlocked.

"Perhaps management should have seen that the party was getting out of hand, and should have understood that the hangover would be wicked," said Lise Buyer, principal at Class V Group in Portola Valley, California.

There were no headaches for investors who bought equity while Facebook was still private and were able to sell at the $38 IPO price. Goldman Sachs sold 24.3 million shares, which raised $924 million at the IPO price, doubling its original investment. Greylock Partners made 18 times its initial investment, selling 7.6 million shares for $289 million. Microsoft sold 6.6 million shares, which raised $249 million, more than quintupling its initial stake.

Few Appearances

Spokesmen for Morgan Stanley, Goldman Sachs and JPMorgan declined to comment.

Company executives did little to help their cause among shareholders during Facebook's first months as a newly public company.

After Zuckerberg's presentations for investors during the pre-IPO road show, the CEO went four months with few public appearances, doing a July 13 interview with Bloomberg News and defending the company's projections on a July 26 call with analysts. Apart from contributions to that call, which covered second-quarter results, Ebersman and Sandberg also shied away from the limelight.

Silence over the plunging share price and growth prospects did little to allay investors' anxiety, said Paul Argenti, a professor at Dartmouth College's Tuck School of Business in Hanover, New Hampshire.

‘Amateurish' Approach

"There should be more public appearances by the CEO, there should be ongoing media relations activities that help give confidence to investors," Argenti said. "I don't see any of that going on. I see the exact opposite. It's amateurish."

Zuckerberg returned to the public eye in a Sept. 11 on- stage interview at the TechCrunch Disrupt conference in San Francisco. He acknowledged that the company had made missteps in executing a mobile strategy. Based on the amount of time users spend on mobile, he said, the company should eventually make "a lot more money" via wireless devices than through desktops.

Since May, the company has rolled out new advertising services for its mobile versions. That includes an offering that lets game makers on its service target users to download their applications on smartphones.

Lockup Expirations

Facebook stock has reversed part of the losses suffered since the IPO, climbing 14 percent to $20.23 yesterday since hitting a record low of $17.73 on Sept. 4.

Yet the shares will probably come under more pressure starting in mid-October, when holders of more than a billion shares, many of them employees, will be permitted to sell.

At $20 a share, Facebook trades at 42 times estimated 2012 profit, still more than twice Google's price of less than 18 times profit.

Among more than 40 lawsuits related to Facebook's offering, some investors blame their losses on trading errors by Nasdaq, where Facebook is listed. Others claim company managers didn't disclose revised revenue forecasts in the days before the stock started to trade publicly on May 18, or they didn't warn that a surge in mobile users would slash revenue.

Facebook has said the suits, which have been consolidated under one judge in federal court in New York, lack merit. If Facebook can prove it disclosed all the risks adequately pre- IPO, the suits may be an uphill battle for investors.

‘Huge Risk'

The IPO proved a harsh lesson to first-time investors like Linda Lantz, an online marketer in Granite Bay, California, who bought 100 shares in the offering with hopes of Internet riches.

After losing close to $1,500 in the four months since, Lantz has an appreciation for the difficulty in valuing social media companies with many users and relatively small profits, she said in an interview.

"The problem with Facebook is that it's not a tangible good, and because it's not a tangible good, people can't feel and touch it, and it definitely has a huge risk of doing what it did," Lantz said, "and that's to go down."

To contact the reporters on this story: Linda Sandler in New York at; Brian Womack in San Francisco at; Douglas MacMillan in San Francisco at

To contact the editor responsible for this story: Tom Giles at

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