One big red flag for Facebook investors: Zuckerberg’s iron grip

Facebook’s initial public offering is one of the most eagerly anticipated technology IPOs since Google went public in 2004: It is a launch that values the social network at more than $100 billion, and it has sparked a number of debates about the future of the company, including whether social advertising is effective or not and whether the company is failing to take advantage of mobile properly. But there is another issue investors should be concerned about when they look at Facebook, and it is arguably even more important than any of these operational questions: namely, the iron grip co-founder and CEO Mark Zuckerberg has over the shares of the company.

For someone who only just turned 28, Zuckerberg wields an almost unprecedented amount of power over the fate of Facebook — not just over the votes that go along with shares of the company but also over the board of directors. The secret to this tight grip is buried in the history of the social network and in particular in the advice Zuckerberg received from former Napster founder Sean Parker, who was a mentor to the Facebook founder and at one time was president of the social network. The implications of what he helped Zuckerberg construct are profound and create a substantial investment risk.

Sean Parker helped Zuckerberg take control of the company

Long before Facebook became the giant it is today, with almost a billion users and revenue of more than $2 billion, Parker advised its young CEO that he should do everything he could to hang onto control of his company. This advice was based on Parker’s own experiences at Napster and another company called Plaxo, where he was removed by the board. So when Facebook took its initial funding round in 2005, he convinced Zuckerberg to push for control over two seats on the board of directors. And when Parker left the company that same year (after some bad publicity over a drug charge), he gave Zuckerberg his seat as well.

That gave the Facebook CEO control over three of the company’s five board seats. But that was just the beginning: In 2009, the board (which he controls) created a new class of “super-voting” shares that have 10 votes per share, compared with the single vote normal shares have. Through his ownership of a chunk of these super-voting shares, Zuckerberg controls almost 30 percent of the votes in the company. Plus, he has proxy agreements with a number of other shareholders, including co-founder Dustin Moskovitz, that give him control over their shares as well.

In all, these various arrangements give the Facebook CEO control over the board of directors and about 58 percent of the votes in the company. If Zuckerberg decides to do something, he doesn’t even have to ask for permission from the board or put it to a shareholder vote (or if he does the latter, he knows he can prevail). Investors got a tangible example of what this means last month, when Facebook announced it would be acquiring the hot mobile photo-sharing service Instagram for $1 billion. According to a number of reports, Zuckerberg told the board of directors about this billion-dollar deal later — via email.

Super-voting shares are popular, but are they wise?

The visionary founder who controls the progress of the company he founded with an iron fist has become a Silicon Valley archetype, thanks in large part to Apple CEO Steve Jobs, who was famously ejected from the company he co-founded due to his erratic behavior. He returned later to rescue Apple from certain disaster and transform it into one of the most valuable companies in history, giving every startup founder a reason why he too should be allowed to control every aspect of his company, regardless of things like shareholder rights.

Google also helped popularize the idea of multiple-voting shares, which gave co-founders Larry Page and Sergey Brin and former CEO Eric Schmidt effective control over the company. In Google’s offering prospectus when it went public in 2004, the co-founders argued this kind of arrangement was necessary in order to ensure Google remained true to their long-term vision rather than getting sidetracked by questions of short-term financial value.

A number of other tech companies have chosen this same route, including both LinkedIn and Zynga. They have also made the argument that dual-class shares are necessary to protect the company and its vision from the vagaries of the daily stock market. (What many of these companies don’t say is that such structures also make it a lot harder to acquire the company, something that has made multiple-voting shares popular with media companies such as the New York Times and Washington Post.)

Multiple-voting shares are a double-edged sword

So why should investors be wary of multiple-voting shares? Because while they protect the long-term vision of the founders of a company, they can also protect the founders from the kind of shareholder action that is often necessary when a company loses its way. Yahoo and AOL, for example, have both been the target of lobbying efforts by activist shareholders who argue they have been mismanaged and that their share price has been damaged. If either AOL or Yahoo had provisions like Facebook does, there would be no hope of ever changing anything at either company.

As a number of shareholder-rights groups and activists pointed out in advance of Facebook’s IPO, tapping the public markets for funding is supposed to bring with it certain responsibilities on the part of corporate executives — including a duty to be answerable to common shareholders and for any failure to act in the best interests of those investors. If companies don’t want to abide by those rules, the argument goes, they should remain private and seek funding from banks or private venture-capital groups.

In a recent report about Facebook’s voting structure, the activist group Institutional Shareholder Services said the dual-class structure is “an autocratic model of governance” that makes Facebook “less viable than a competitor whose governance gives owners a voice proportionate to the economics they have at risk.” The group also criticized the growing trend for such super-voting shares, saying, “Facebook appears to have taken the same outdated dance lessons as many other recent tech sector debutantes.”

Having Zuckerberg control 58 percent of the votes at Facebook isn’t likely to be a problem for anyone as long as the company is making smart decisions about what to do with its money and as long as the stock price is going up. But if it starts to go south and Facebook makes some unwise decisions, it will become obvious that such voting structures are a fair-weather friend: They are great to have when things are going well, but they can become a huge liability.