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Long-term investments in Facebook could be a bad bet, experts warn

Brian Snyder / Reuters

Facebook founder and CEO Mark Zuckerberg.

Investors, social media watchers and Facebook users may be looking forward to the social network’s expected public stock offering later this year, but corporate governance experts aren’t quite so enthusiastic.

Earlier this month, Facebook filed for a $5 billion IPO -- a deal that would be one of the biggest public stock offerings ever and values the social media juggernaut at about $100 billion.

Those sorts of numbers, coupled with the company’s strong brand name, are likely to draw interest from individual investors eager to buy a piece of the company. Governance experts caution, however, that while buying a hot company like Facebook feels good now, potential investors should be wary of the stringent executive control structure outlined in the company’s IPO registration document.

“Right now you have a situation at Facebook where there’s a benevolent dictatorship, but my concern is they tend to become malevolent dictatorships, and that can hurt you when it comes to the pinch,” said Aswath Damodaran, a professor of finance at New York University's Stern School of Business.

Damodaran notes that, based on information in the company’s filing with the Securities and Exchange Commission, Facebook’s founder and Chief Executive Mark Zuckerberg would retain complete control of the company for the foreseeable future and would even have the right to appoint his own successor before he dies.

Facebook has also set up defenses against takeovers and proxy fights, when shareholders unite to force changes at the directorial and management level.

Key to Facebook’s stringent control structure is its dual stock ownership structure, where a company issues two classes of shares with different voting and ownership rights. The system allows the company’s founders and management to maintain control, but still solicit investments from the public, Damodaran said.

“This system has been foreign to the U.S. and for a long time it wasn’t a common thing here, but you can blame Google for its return,” he said, noting that the search firm used the format when it launched its IPO in 2004 and has inspired a number of the new Internet technology firms now launching IPOs to follow suit.

“Whether this is fair or not fair, people still want to buy stocks like Facebook because this is a hot sector, and when that’s the case companies can basically write the rules,” Damodaran said. “I don’t have any objections to Zuckerberg as a CEO; I think he has done a good job. But I don’t think it’s in shareholders’ interests to sign him on for life. Investors should discount the possibility that there’s a crisis for the company down the road, and if one happens they will not have much of a say.”

A case in point is Yahoo, Damodaran added. Fifteen years ago the search company was the darling of Wall Street, well managed and well run. Ten years later it was a “disaster waiting to happen” and rejected Microsoft’s multi-billion dollar takeover offer that some shareholders may have preferred it to accept.

“So let’s say for example that in 10 years’ time there’s some disaster at Facebook and it receives a takeover offer from Apple,” he continued. “Shareholders might want the company to take the offer, but if Zuckerberg says it can’t go through it doesn’t happen. Sometimes it’s best for a company in trouble to clean house and do away with management and the board and be acquired at the best price.”

If you’re planning on buying Facebook’s shares in the hopes that the company will eventually update its governance structure, you’re likely to be disappointed, notes Matthew Rhodes-Kropf, a professor at Harvard Business School who specializes in corporate governance issues.

“The evidence suggests that the corporate governance structure you have in place when you go public tends to stay in place,” he said.

But companies have an incentive to put in place a governance structure that leans more toward a democracy than a dictatorship, he added, pointing to research that shows greater democracy toward shareholders increases a company’s return on assets -- a measure of its profitability -- and its stock performance.

“So managers should be responsive to their shareholders, but in the end we all want roughly the same thing -- we want the company running well and we want it to make a profit, so we should probably leave them alone,” he said.

I wouldn’t want a company manager to listen to every whim of their shareholders, like politicians who pander to every whim of the electorate, he said.

“It’s not a brilliant way to run the country and not good way to run a firm.”

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