S-1 Journal

The 10 Questions
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Every S-1, decoded through the same 10 questions.

One in Eight People on Earth Uses It.
On Mobile, It Earns Nothing.

In February 2012, Facebook filed its S-1. Monthly active users (MAU): 845 million. Of the world’s 7 billion people at the time, one in eight used the service.

Revenue was $3,711 million, net income $1,000 million. An operating margin of 47% — nearly half of all revenue dropping through as profit, an extraordinarily high level.

And yet — the S-1 contains a sentence that is extraordinary for a company of this scale: “We do not currently directly generate any meaningful revenue from the use of Facebook mobile products.” More than half of all users were accessing Facebook from mobile, and ad revenue from there was zero.

Founder Mark Zuckerberg was 27. He held 55.8% of the voting power by himself (per the S-1/A). What the S-1 shows is a company in which a 27-year-old controls one in eight people on Earth and heads into the largest Internet IPO to date with zero mobile revenue.

Ten questions. We lay out only what the S-1 says.

Question 1

What is this company, really?

In one line: a social networking service that connects people to people.

Facebook’s mission is “to make the world more open and connected.”

Users create a profile under their real name. They post text, photos, and video, and friends, family, and colleagues respond with “Likes” and comments.

The scale is extraordinary. In 2012 the world had about 7 billion people and more than 2 billion internet users (S-1). Facebook was a service used by roughly 40% of the internet population.

A communication infrastructure on a planetary scale — that is what Facebook was in 2012.

Question 2

What does it compete on?

Facebook competes in three distinctive ways.

Real names x the social graph

Facebook’s greatest moat is the real-name policy. Unlike anonymous message boards or handle-name cultures, users register under their real names and bring their real-world relationships directly onto the platform.

The S-1 puts it this way: “People use Facebook to stay connected with their friends and family, to discover what is going on in the world, and to share and express what matters to them.”

This social graph (a map of human relationships) grows more valuable the more users there are. Your friends are on Facebook, so you use it too — a textbook network effect. A real-name social graph of 800 million people cannot be replicated by anyone else.

News Feed (the algorithm that owns your time)

The “News Feed” that flows across Facebook’s home screen reorders friends’ posts by algorithm, surfacing the posts a user is most likely to care about.

This is what generates time spent. Users spend tens of minutes a day on Facebook on average. It is a machine for taking time away from television and newspapers.

Facebook Platform (an ecosystem that pulls in developers)

At the time of the S-1, more than 7 million apps and websites integrate Facebook Platform. They install a “Log in with Facebook” button and tap into the social graph.

The biggest example is Zynga (the social-game maker behind FarmVille and others). In 2011, Zynga accounted for about 12% of Facebook’s total revenue.

Real-name social graph + News Feed + Platform — it held human relationships themselves.

Question 3

How big is the market?

The market comes down to three numbers.

The S-1’s The Opportunity section starts with the size of the market. Global advertising spend was $588 billion in 2010 (the S-1 attributes this to “an industry source”). Of that, online advertising was projected to grow from $68 billion in 2010 to $120 billion in 2015 — its share of global ad spend rising from 12% to 16%.

But the real message lies elsewhere. It is written this way: “We believe that the shift to a more social web creates new opportunities for businesses to engage with interested customers.”

Offline advertising moves online, then on to social and mobile. Facebook is positioned to catch both tailwinds at once — that is the message.

Online + social + mobile — positioned to catch three tailwinds at once.

Question 4

Who actually uses it?

Let’s lay out Facebook’s “users” in numbers.

What stands out is mobile MAU of 425 million. More than half of all users access Facebook from mobile.

And yet — mobile ad revenue is zero. This is the greatest tension in Facebook’s S-1. User behavior is moving to mobile, but Facebook has no way to make money from that move.

845 million people — roughly 40% of the planet’s internet population — had gathered on a single service. But on half of their phone screens, Facebook was earning nothing.

On half of 845 million users’ phone screens, Facebook was earning nothing.

Question 5

How does it make money?

Facebook has two sources of revenue.

Advertising is mainly of two kinds: self-serve ads shown in the right-hand column of the Facebook screen, and Sponsored Stories (native ads that run inside the News Feed, launched in 2011).

Advertisers can target. A user’s age, gender, location, interests, relationships — thanks to real names plus self-reported data, ad delivery is more precise than any other medium.

Payments is mainly from social games such as Zynga. When virtual goods are sold on Facebook Platform, Facebook collects a fee of up to 30%.

Annual revenue per user (ARPU) was $5.11 on a global average in 2011 (per the S-1/A; rising $3.08 in 2009 -> $4.08 in 2010 -> $5.11 in 2011). Regional differences are large, with the US and Canada standing out at the top and Asia and other regions lower. Multiply that unit figure by 845 million monthly users and you reach 2011 total revenue of $3,711 million.

$5.11 per user per year, across 845 million monthly users — 2011 total revenue of $3,711 million.

Question 6

Are the numbers healthy?

Revenue up 4.8x in three years. And already profitable.

Start by laying out the financial facts.

What stands out is the operating margin of 47%.

Anomaly: a 47% margin is extraordinarily high

Facebook’s operating margin of 47% is an extremely high level for a tech company.

The reveal is simple. Facebook’s service is, in essence, made by its users. Content production cost is zero. Apart from data centers and engineers, the structure incurs almost no variable cost.

The conclusion

As of the end of 2011, cash plus marketable securities was about $3.9 billion. “Revenue up 5x in three years, a 47% margin, about $3.9 billion in cash” — numbers that look perfect.

But there is one bomb. Zero mobile revenue. This connects directly to the biggest risk in Question 9.

Numbers that look perfect, but one bomb — zero mobile revenue.

Question 7

Who runs it?

Facebook is a company controlled by one man.

The S-1 includes “A Letter from Mark Zuckerberg.” Zuckerberg defines the reason the company exists like this.

“

Simply put: we don’t build services to make money; we make money to build better services.

FACEBOOK S-1 (FEB 2012) — LETTER FROM MARK ZUCKERBERG

In an IPO document, he declared plainly that the company’s purpose is not shareholder returns but the mission.

Mark Zuckerberg (Founder, Chairman & CEO)

Aged 27 at the time of the S-1 filing. He had served as CEO since 2004 and studied computer science at Harvard University.

Sheryl Sandberg (COO)

Appointed in 2008; previously a VP at Google. An advertising-business specialist, she led the monetization of Facebook’s advertising. She brought the ad-targeting methodology established at Google to Facebook.

The structure

A 27-year-old founder wrote that it “is not for the money.” And yet he ran a company with about $3.7 billion in revenue and a 47% margin. Eight years out of Harvard, he had built the most widely used service in the world.

Eight years out of Harvard, he had built the most widely used service in the world.

Question 8

Who controls it?

This is the core mechanism of Facebook’s S-1.

It is a dual-class structure, just like Google’s “one share, 10 votes.” One man holds 55.8% of the voting power. Even if every other shareholder votes against him, Zuckerberg cannot be overruled. He holds a majority by himself.

This is possible because, on top of his own Class B stock, he holds proxies from other shareholders. Director James Breyer (Accel) and others have entered into agreements to assign their voting rights to Zuckerberg.

Facebook is Zuckerberg’s company. Even selling roughly $16 billion of stock in the IPO does not dilute his decision-making power by a millimeter. A 27-year-old founder controls the most widely used service in the world by himself.

What protects this

The S-1 states it clearly: “Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval” — including the election of directors and any merger, consolidation, or sale of assets.

In other words, the election of directors and the sale of the company can both be decided by Zuckerberg alone. The Risk Factors then warn investors plainly.

“

This concentrated control will limit your ability to influence corporate matters.

FACEBOOK S-1 (FEB 2012) — RISK FACTORS, CONTROL

A 27-year-old controls the most widely used service in the world by himself.

Question 9

What is it afraid of?

Here are the five things Facebook itself says it worries about most.

The shift to mobile (the biggest risk)

The clearest and most serious risk in the S-1 is this one.

“

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.

FACEBOOK S-1 (FEB 2012) — RISK FACTORS, MOBILE

Users are shifting to mobile (more than half of MAU are on mobile). But Facebook has not yet established a way to show ads on mobile. Desktop ad revenue falls and mobile ad revenue does not rise — if that scenario plays out, revenue growth stops.

Dependence on Zynga

Nearly all of the $557M in 2011 Payments revenue came from social games, led by Zynga. Zynga also buys ads directly, so counting fees and advertising together, about 12% of total revenue is tied to Zynga alone. A downturn at Zynga hits Facebook directly.

Risk of users leaving

The S-1 warns that if Facebook fails to retain existing users or add new users, its revenue and financial results may be adversely affected. The possibility that 845 million users move to another service. The S-1 names Google, Microsoft, Twitter, and Google+ as competitors.

Privacy regulation

The S-1 warns that governments around the world are considering laws on the collection, use, and disclosure of personal information. The user data Facebook holds (real names, relationships, location, behavioral history) sits at the front line of tightening regulation. The S-1 notes that a revision of the 1995 EU Data Protection Directive was under consideration at the time — the seed of stronger privacy regulation was already visible in 2012.

The risk of founder control

The S-1 itself lists this as a Risk Factor: Mr. Zuckerberg controls the direction of the business, and his interests may not always be aligned with the shareholders’. The absence of any external check on a founder’s misjudgment is recognized as a risk.

Zero mobile advertising, single dependence on Zynga, user departures, privacy, and founder control. Five in all.

Question 10

What becomes of the money it raises?

Note: This analysis draws only on the facts in the S-1. The final IPO price, the listing date, post-listing share performance and trading demand are not in the filing and fall outside its scope.

The IPO plan goes like this.

The implied amount raised is on the order of $5 billion. At the time, it was on track to be the largest Internet IPO to date.

Use of proceeds

The use is “working capital and other general corporate purposes.”

No specific projects (so many dollars for mobile development, so many for data-center expansion) are spelled out. It is “raise the money, and the company decides where it goes.”

Not a stopgap, but a cash-out for the founders

Facebook is already profitable and holds $3.9 billion in cash. More than a need for funding, the offering carries the meaning of a cash-out opportunity for founders, early investors, and employees.

In particular, it is made clear that the offering includes secondary shares from existing holders. The design is for Zuckerberg to retain his voting power while early investors cash out.

A bet on mobile revenue

The money raised in the IPO also becomes the capital to fund building a mobile-advertising methodology. “Buying time with money to solve zero mobile revenue” — that is the essential meaning of Facebook’s 2012 IPO.

“Buying time with money to solve zero mobile revenue” — that is the essence of Facebook’s IPO.

In closing

Beyond the ten questions

What Facebook is selling is not merely a “social networking service.” MAU of 845 million, roughly 40% of the planet’s internet population, 57% engagement, more than 70 languages, 250 million photos a day. Revenue up 4.8x in three years, a 47% operating margin, $3.9 billion in cash. A real-name social graph of 800 million people that no one else can replicate.

But that S-1 states, “We do not currently directly generate any meaningful revenue from the use of Facebook mobile products.” More than half of all users come from mobile, yet ad revenue there is zero. It discloses this in the Risk Factors as its biggest risk. Zynga alone is 12% of total revenue, and a revision of the EU Data Protection Directive (stronger privacy regulation) looms overhead.

And the 27-year-old founder, Mark Zuckerberg, holds 55.8% of the voting power by himself, through Class B stock at 10 votes per share plus proxies. The election of directors and the sale of the company can both be decided by Zuckerberg alone. The S-1 itself warns that “this concentrated control will limit your ability to influence corporate matters.” Eight years out of Harvard, he heads into the largest Internet IPO to date.

The S-1 writes that it will “make the world more open and connected.” The market expects “the winner of the great migration of advertising from online to social to mobile.” At the intersection of the two, Facebook sells stock. It is the moment a 27-year-old founder heads into the largest Internet IPO to date, still carrying the bomb of zero mobile revenue.

Source: All facts are drawn from Facebook, Inc.’s S-1 (accession 0001193125-12-034517, filed 2012-02-01), together with the company’s IPO roadshow presentation and factsheet where noted.