Regulators Prepare to Examine the Facebook IPO

It's here: The long-time-coming Facebook initial public offering that is expected to be one of the largest in history, seeking to raise $5 billion in capital, on its way to an estimated valuation between $75 and $100 billion. But before the IPO comes the S-1, the IPO's regulatory antecedent. See, “Facebook Files for an I.P.O.,” NY Times.com, http://nyti.ms/zTogEx.

The S-1 filing from the 800 million-user social network is the big reveal ' pages and pages of single-spaced text spelling out the company's risk factors, business model and financial records, all of which will be held up to the scrutiny of the Securities and Exchange Commission (SEC). (The filing is available at http://1.usa.gov/wgemKY.)

It can be a company's most arduous securities filing, and may even form the basis of future lawsuits if investors were to charge they were misled. The level of detail on display, says University of California Berkeley law professor Eric Talley, evokes Norma Desmond's famous line from Sunset Boulevard: “All right, Mr. DeMille, I'm ready for my close-up.”

Scrutinizing Disclosures

So once regulators zoom in on the company that started out of CEO Mark Zuckerberg's Harvard University dorm room, what will they be looking for? 

The SEC won't be making a call as to whether buying Facebook shares is a “good investment,” says Santa Clara University law professor Stephen Diamond. Rather, they'll be making sure investors have all the material information they need, presented in a clear enough manner to allow potential stock holders to make that determination for themselves.

“The major legal issue at this point is essentially providing that kind of disclosure to the investing community,” Diamond says.

The three top areas of concern for regulators, says Diamond, are: 1) whether or not the company's financial records are presented accurately; 2) the presentation of risk factors, such as the capital structure of the business; and 3) the description of the business. In other words, “how Facebook says it makes money and how it plans to make money in the future, and whether or not its claims about the success of the company are accurate.”

For instance, the SEC would want the company to define what it means by the term “user.” “Does that mean someone comes on once every six months, and therefore they're a user” asks Diamond, “or is it someone who uses it on a daily basis?”

Valuing Assets

Another area that may draw questions is how Facebook values its assets. Given the Internet tech sector's reliance on intangible assets ' such as intellectual property rights and their growth opportunities in a rapidly changing field ' “this is sometimes quite difficult for a lot of tech companies,” says Talley, who is also director of the Berkeley Center for Law, Business, and the Economy. The question, Talley says, becomes: “How do I value the network effect of the fact that Facebook is, by an order of magnitude, the largest social networking site in the world?”

Over the course of three, four, or even five months, in some cases, regulators can be expected to pepper the issuer with questions, effectively asking the company to prove, justify or clarify anything they have stated, says Donald Reinke, a partner at Reed Smith who specializes in venture capital finance and public securities offerings in the tech sector.

“They'll go line by line through that entire registration statement, and ask a whole host of questions,” he says. “And sometimes you'll answer all the questions, and get the same questions back again, at which point it's prudent to pick up the phone and talk with your examiner to make sure you're on the same page in terms of what they're looking for.”

Regulators may also scrutinize company materials released to the public prior to the filing of the S-1, says Reinke. “They'll scrutinize your press releases and your public announcements, and often compare those to what's in your S-1, and ask, perhaps, why the two don't correspond to one another. For example, 'You made these statements that you're the leading XYZ company ' prove that to us.'”

Keeping It Quiet

At the same time that regulators are fashioning their comments, the issuer also has to comply with SEC regulations that govern the so-called “quiet period.” Says Diamond: “The concern becomes that you not engage in publicity that has the effect of arousing public interest unduly in the stock.”

It's a fine line to assess, say both Reinke and Talley. On the one hand, companies aren't expected to cease day-to-day business activity, like hawking the launch of a new product or feature. On the other hand, “you don't really want to be shilling for your IPO,” adds Talley.

Those restrictions often prove particularly trying for counsel, says Talley. It can be difficult to advise a company's executives ' such as the CEO or the CFO ' who are used to interfacing with the public that “you can't be perceived as trying to promote the IPO.”

As regulators and potential investors examine the social networking company's operations under a fiscal microscope, it will only be a matter of time before the stock market gets to decide just how much it “likes” Facebook.

It's here: The long-time-coming Facebook initial public offering that is expected to be one of the largest in history, seeking to raise $5 billion in capital, on its way to an estimated valuation between $75 and $100 billion. But before the IPO comes the S-1, the IPO's regulatory antecedent. See, “Facebook Files for an I.P.O.,” NY Times.com, http://nyti.ms/zTogEx.

The S-1 filing from the 800 million-user social network is the big reveal ' pages and pages of single-spaced text spelling out the company's risk factors, business model and financial records, all of which will be held up to the scrutiny of the Securities and Exchange Commission (SEC). (The filing is available at http://1.usa.gov/wgemKY.)

It can be a company's most arduous securities filing, and may even form the basis of future lawsuits if investors were to charge they were misled. The level of detail on display, says University of California Berkeley law professor Eric Talley, evokes Norma Desmond's famous line from Sunset Boulevard: “All right, Mr. DeMille, I'm ready for my close-up.”

Scrutinizing Disclosures

So once regulators zoom in on the company that started out of CEO Mark Zuckerberg's Harvard University dorm room, what will they be looking for? 

The SEC won't be making a call as to whether buying Facebook shares is a “good investment,” says Santa Clara University law professor Stephen Diamond. Rather, they'll be making sure investors have all the material information they need, presented in a clear enough manner to allow potential stock holders to make that determination for themselves.

“The major legal issue at this point is essentially providing that kind of disclosure to the investing community,” Diamond says.

The three top areas of concern for regulators, says Diamond, are: 1) whether or not the company's financial records are presented accurately; 2) the presentation of risk factors, such as the capital structure of the business; and 3) the description of the business. In other words, “how Facebook says it makes money and how it plans to make money in the future, and whether or not its claims about the success of the company are accurate.”

For instance, the SEC would want the company to define what it means by the term “user.” “Does that mean someone comes on once every six months, and therefore they're a user” asks Diamond, “or is it someone who uses it on a daily basis?”

Valuing Assets

Another area that may draw questions is how Facebook values its assets. Given the Internet tech sector's reliance on intangible assets ' such as intellectual property rights and their growth opportunities in a rapidly changing field ' “this is sometimes quite difficult for a lot of tech companies,” says Talley, who is also director of the Berkeley Center for Law, Business, and the Economy. The question, Talley says, becomes: “How do I value the network effect of the fact that Facebook is, by an order of magnitude, the largest social networking site in the world?”

Over the course of three, four, or even five months, in some cases, regulators can be expected to pepper the issuer with questions, effectively asking the company to prove, justify or clarify anything they have stated, says Donald Reinke, a partner at Reed Smith who specializes in venture capital finance and public securities offerings in the tech sector.

“They'll go line by line through that entire registration statement, and ask a whole host of questions,” he says. “And sometimes you'll answer all the questions, and get the same questions back again, at which point it's prudent to pick up the phone and talk with your examiner to make sure you're on the same page in terms of what they're looking for.”

Regulators may also scrutinize company materials released to the public prior to the filing of the S-1, says Reinke. “They'll scrutinize your press releases and your public announcements, and often compare those to what's in your S-1, and ask, perhaps, why the two don't correspond to one another. For example, 'You made these statements that you're the leading XYZ company ' prove that to us.'”

Keeping It Quiet

At the same time that regulators are fashioning their comments, the issuer also has to comply with SEC regulations that govern the so-called “quiet period.” Says Diamond: “The concern becomes that you not engage in publicity that has the effect of arousing public interest unduly in the stock.”

It's a fine line to assess, say both Reinke and Talley. On the one hand, companies aren't expected to cease day-to-day business activity, like hawking the launch of a new product or feature. On the other hand, “you don't really want to be shilling for your IPO,” adds Talley.

Those restrictions often prove particularly trying for counsel, says Talley. It can be difficult to advise a company's executives ' such as the CEO or the CFO ' who are used to interfacing with the public that “you can't be perceived as trying to promote the IPO.”

As regulators and potential investors examine the social networking company's operations under a fiscal microscope, it will only be a matter of time before the stock market gets to decide just how much it “likes” Facebook.