Law in the Internet Society

Paying Attention to Facebook

The social network’s recent IPO has captured the headlines of Wall Street’s media as the company looks to raise $5 billion dollars as soon as May of this year. As projections of its value continue to climb past $100 billion dollars, many analysts are looking to the company’s filings with the SEC to gauge its potential growth. The company only needs to make a small percentage of its stock open to outsiders yet is able to augment the net worth of its insiders and allow an exit for the venture capital angel investors, while also using its new capital infusion to essentially whatever it would like as it is in an industry in which it is difficult to determine what is in the shareholder’s interest. As Professor Moglen points out, among the host of defects in its filings, Facebook’s fundamental structure is inferior to federated social network, the latter of which has the potential to displace Facebook and marginalize Facebook’s returns. As the crown jewel of a string of exorbitantly priced Net driven IPO’s, the debate surrounding Facebook’s future highlight’s the likelihood that misallocation of capital due to irrational asset pricing and investor ignorance with respect to Net based applications and services could lead to a crisis in American securities markets.

Ghosh and Goldhaber provide an understanding of the new economic order which will describe an internet society. A key component of both thought is that scarcity of human thought and attention, and the idea that perpetually attracting attention will require, to some extent, originality. What separates Facebook, Zynga, and Linkedin from the internet giants of the 2000’s such as Google, Amazon, and Ebay is that they are a second order deviation from “real” goods and services. Amazon and Ebay are marketplaces which allow (or for Professor Moglen, coerce) consumers to find and obtain goods they want, while Google has become a comfortable portal to the Net for its users. As Moglen establishes in class, all of these companies are able to aggregate data and undermine privacy in order to capture consumer surplus in the sales of goods through targeted advertising and price discrimination. Though this is probably true, the companies must continue to attract the attention of the customers it will exploit, a weakness Facebook itself acknowledges on Page 15 of its S-1. Furthermore, Facebook’s mobile application currently does not generate any revenue, something which will have to change as people continue to spend more time on the Net away from their personal computers.

At $100 billion dollars, Facebook’s price/earnings ratio will be somewhere around 166, making it extremely expensive. To justify such a valuation, the company will need to rapidly increase revenues while maintaining a high profit ratio over the next decade. No doubt Facebook has a broad grasp over inhabitants of the Net: they report having 845 million users and this number is growing everywhere except in China. At such a rate, Facebook helps people answer their intimate questions, especially in a first world society in which people define themselves in part through their relationships with others. (I like to think Facebook provides those my age, in addition to knowledge of who is getting laid by whom, is a sense of the opportunity cost of one’s time with respect to other activities, interests, and friendships they could be pursuing, all in a very succinct and readable format, though this probably a whole other essay for a different course). But the fact remains that this is not a company for which it is easy to perform a comparables analysis. It is not a company which has a high liquidation value (unless you could sell stores of data). A back of the envelope discounted cash flow, using assumptions based on 3.71 billion dollars revenue in 2011 and a similar EBIT trajectory as Google faced in 2004, yields a value of around $65 billion dollars, significantly below the anticipated market price (though it still seems outrageous).

Our securities regulation, despite being considered to be a robust disclosure and enforcement regime, is not equipped to deal with the uncertainty and speculative nature involved with the securities financing 21st century technology. The fundamental dichotomy underlying all of the regulations is a distinction between sophisticated and lay investors, which in this context differentiates between people who understand how the market works but know nothing about technology, and people who don’t anything about anything. One potential avenue to attack irresponsible securities offerings was recently provided by the Second Circuit. In Landmen Partners, Inc. v. The Blackstone Group, L.P., the Court focused its materiality analysis on an individual business segment and environement rather than the publicly-reporting entity itself, which will likely incentivize plaintiffs to avoid the traditionally-accepted 5% materiality threshold. The court found that the absence public information which pertained only to the business environment could still be material misstatements or omissions regarding “significant” or “important” aspects of an issuer’s business even if they fall below the 5% numerical threshold. This sort of analysis and case law could be applied by courts to perhaps provide materiality guidelines applicable to Net companies which may stem the tide of irrational share pricing. Landmen Partners was brought under Sections 11 and 12(a)(2) of the 33 Act, two provisions most directly pertaining to registration statements. In the arena of Rule 10b-5 and “fraud on the market” litigation, plaintiffs will struggle to pin potential earnings shortfalls to misleading statements made by insiders of large Net companies for many of the same reasons discussed above. Furthermore, after the initial public offering stage, issuers and underwriters can avail themselves of protections under 33 Act Section 27A, enacted by the Private Securities Litigation Reform Act, which provides strong protections for forward-looking statements.

-- By MeharJagota - 05 Apr 2012

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r3 - 04 Sep 2012 - 22:02:25 - IanSullivan
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