Three Headwinds for Facebook's IPO

I am not pessimistic about Facebook's future. I have used the social network for eight years and continue to be impressed with Mark Zuckerberg's focus on product and his vision for the internet. When I logged into the site for the first time in the spring of 2004, I was prepared to hate the service. It was just weeks until Zuckerberg's addictive platform won me over. And that was a far inferior Facebook: a sophomoric site where Zuck's own silhouette still hovered in the top left corner of every page. Today, I still use the site. I find frivolous but satisfying content every day in the newsfeed. And the open graph has made countless websites and internet services immensely more valuable for me.

If I am at all indicative of the population, Facebook will be around and culturally significant for a while. But equity investing and product use are very different things. And despite all of Facebook's user support, investors should be skeptical of the company's pricey IPO.

Three factors could impede Facebook's growth:

1. Increasing Shift to Mobile Utilization will Continue to Hurt Advertising

   Through its website, Facebook has built a massive advertising business. By dedicating a small amount of space on every page viewed and allowing companies to display ads, the social networking giant has developed a multi-billion dollar advertising business. According to ComScore, at the end of 2011 Facebook accounted for a shocking 28% of U.S. display advertisements online.

   However, the advertising business is dependent on visits to Facebook's website. As of yet, the company has not built out a compelling mobile advertising platform. And unfortunately for the Facebook investor, mobile internet is becoming increasingly important. Facebook even amended its S-1 to acknowledge to acknowledge the risks to its advertising business from increasing adoption of the mobile format.

   While this is a surmountable problem, it puts the media company in a very different position than that of Google in 2004 - the company that Facebook is most often compared against. When Google IPO'd in 2004, the company's advertising business had tailwinds; internet penetration was only at around 68% in the U.S. (let alone the rest of the world) and amount of use per user was also on the rise. Growth in revenues for Google was inevitable. Facebook's ability to achieve enormous advertising growth, on the other hand, is far less certain.

2. The Open Graph's Value Sits Outside Facebook's Walled Garden

   Most people don't realize just how integral Facebook is to today's internet. Facebook's addition to most consumer websites is far greater than the "Connect with Facebook" button you see at login screens. Companies using the Facebook API gain access to social network information. Web developers can personalize recommendation engines, allow users to see their friends' purchase history, and draw on detailed demographic data available through the Facebook network.

   Over the past couple of years, I've become close with a handful of web product managers. Each of them confirms that what Facebook provides is incredibly valuable in building websites. They believe that the API improves user experience and makes product development both quicker and simpler. But while access to Facebook's API is valuable, much of the value lies outside of Facebook's walled garden, Facebook.com. The business of augmenting sites like Kickstarter and Washington Post, while immensely important, likely isn't destined to yield enormous cash flows; since it's difficult to quantify on an external site Facebook exact benefit.

   What's worse, Facebook's efforts to bring transactions inside the walled garden - through Facebook Storefronts - seem to be decreasingly important to large e-commerce players as they discover the high costs and low returns of doing business on the site.

3. Private Market Valuations aren't Great Indicators of Public Returns

   The final reason for trepidation is probably the most important. There is a lot of emotion behind the Facebook IPO. Main Street investors are not only likely to be users of the product, but they are also likely to be well aware of the company's meteoric rise.

Less than three years ago, Facebook was valued at just 10B by Yuri Milner's Digital Sky Technologies. Since his fund's investment, a series of very well publicized auctions on secondary markets have driven Facebook's private market valuation to over 85B. Anyone who's noted the 750% return in just over two years is likely enthusiastic about Facebook's potential. It's feels like catching a rocket right at lift-off.

The problem for most Main Street investors is that they don't necessarily appreciate the dynamics of the private markets. Venture investors look for home runs. They invest millions in the hopes of achieving billions in returns. For every 10 investments, a good firm may have one defining investment, returning hundreds of percent in IRR. Whether Facebook IPOs for 80B or 100B, the venture funds that invested prior to 2011 will have plenty of capital to return to their limited partners. However, the public market investor is looking for very different opportunities. Because most are searching for predictable growth over the next five to 10 years (while VCs were looking for explosive growth over the last seven years), the potential of a 20% swing in valuation is enormous. VCs who bought at valuations around the 10B mark are going to do just fine regardless.

Facebook is not Groupon. I don't mean to suggest it will fall 70% in value after its IPO pop. But it's also not yet clear that Facebook is the next Google; it doesn't have massive tailwinds propelling its business model. It's certainly not clear that the firm will deliver returns similar to Apple over the last decade; if you expected Facebook to be the next Apple, it would have to be worth well over four trillion dollars ten years from now. For what it is — an uncertain bet — Facebook is going to be expensive. To offer a benchmark, at IPO Facebook will trade at a market value near that of Amazon — a company that has built an international distribution network, a media empire, and an unparalleled web services business. That may be sensible, but it's certainly not obvious.