Social Media December 3, 2009, 12:58AM EST

Facebook Must Woo Investors Before Any IPO

The social networking site has ascended to Silicon Valley stardom. As it heads toward a possible share sale, it will next need to win over Wall Street

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Google has become one of the most sought-after tech stocks this decade, but it wasn't always considered a sure bet. In the runup to Google's (GOOG) 2004 initial share sale, some investors fretted that, at $85, the Web search company was overvalued.

These days, fund managers are running a slide rule over a new Silicon Valley darling that may be headed for an IPO: Facebook. Some potential shareholders have yet to be convinced Facebook is a stock they want to own. While Facebook tops the social networking heap with 350 million users, it competes in a social media realm notorious for swiftly changing consumer tastes.

Time was, MySpace was the go-to social network, and before that, it was Friendster. Both have since lost allure. "There's no sustainable model that looks great for social networking," says Michael Pytosh, tech analyst for ING Investment Management, which oversees $600 billion.

On Nov. 25, five-year-old Facebook revived speculation it's on track for an IPO when it said it created a dual-class stock structure. The move grants more voting power to existing shareholders than new ones and it's a step typically taken by companies planning to sell shares to the public. "The move was without a doubt done in preparation for an IPO," says Paul Bard, a research analyst at Greenwich (Conn.)-based Renaissance Capital, which researches newly public companies.

Another recent step seen as a precursor to an IPO was the announcement in June that Facebook had hired David Ebersman, a 15-year veteran of Genentech (DNA), to be its chief financial officer. Facebook spokesman Larry Yu says the company has no plans to go public.

The Profit Question

When and if that changes—and analysts speculate a share sale could come as soon as 2010—the profit question will figure prominently for many would-be Facebook investors. In September, the company announced it was cash-flow positive, meaning the cash it generates from advertising and other revenue sources now exceeds the cost of servers and other capital expenditures. That followed a public comment by Facebook board member Marc Andreessen that the company was on track to generate $500 million in revenue in 2009.

The revelations quelled concerns that Facebook lacks a business model. But some fund managers still question the plan for wringing profit in coming years, particularly amid fluctuations in costs for the computers needed to keep the social network running. "We don't know quite what their profit picture is," says Ryan Jacob, chairman and chief investing officer of Los Angeles-based Jacob Internet Fund, which oversees about $36 million.

Facebook's reliance on advertising for much of its revenue also gives some investors pause. Google relies on Internet advertising for its sales, but it uses sophisticated mathematical models to place ads based on products or services that people using Web search may actually be trying to find. Many people don't typically go to Facebook to shop or research products. "People mainly go to social networking sites to network, not to buy," says ING's Pytosh.