One of the biggest stories of the last week was Goldman's $ 500 million investment in Facebook for approximately 1% of the company. Extrapolating from the transaction, we obtain an implied value of $ 50 billion for Facebook, a number that has been making the rounds in news stories over the last few days. There are three questions that emerge from this news story: (a) With private businesses, can you extrapolate from a single transaction amount to an overall value? (b) Why would a company worth billions choose to stay private, when it clearly has the option to go public? (c) How would you value a share in a non-listed, non-traded company (as opposed to a publicly traded company)?
a. Can you extrapolate from a single transaction amount to an overall value?
Sure, as long as the transaction is an arms length one and all you are getting in return for your investment is a share of the company's equity. If, as is common, there are side benefits or side costs that go with the transaction, extrapolation will yielding a misleading estimate of value. In the case of the Goldman transaction, there are plenty of reasons to be skeptical. In addition to getting a piece of Facebook, Goldman also gets the following benefits:
a. Investment opportunities for Goldman's clients: As part of the deal, Goldman will be raising $1.5 billion from its clients to invest in Facebook. While this may seem to be a favor that Goldman is doing for Facebook, the reality is that Facebook is a hot company to invest in and this will allow eager investors an exclusive entree into the company.
b. A front seat for the Facebook IPO: If at some point in time, Facebook decides to go public, Goldman is likely to be the lead underwriter and reap a big share of the commission.
c. Private wealth management services to Facebook's potential billionaires and millionaires: When Facebook goes public, Mark Zuckerberg and a number of other executives will have the capacity to sell their shares in the market. While I do not expect a wholesale cashing out of equity positions immediately after the IPO, it is likely to happen over time, at which point these very wealthy individuals will need some private banking help and Goldman will be there to provide that help.
The profits and fees from these added businesses could account for a significant chunk of the $ 500 million that Goldman paid in this transaction. Exactly how much will depend on the likelihood of an IPO and the fee structure for the transaction. If, for instance, the present value of the expected fees from these side benefits is $ 200 million, the implied value for Facebook will be $ 30 billion, rather than $ 50 billion.
One more note of caution. Strange though this may sound, I would trust a market price derived from a consensus of a thousands of buyers and sellers to get the value right more than I trust the price from a single transaction, even if the buyer and seller are supremely sophisticated.
b. Why would a company worth billions choose to stay private, when it clearly has the option to go public?
Facebook's reluctance to go public may seem surprising. After all, the conventional wisdom has always been that companies like Facebook should get a more favorable response from offering shares in the public market place than from private offerings to venture capitalists and large investors. Here are some reasons, rational or otherwise, for why Facebook may be holding back:
i. Extending the tease: Looking at the favorable publicity that Facebook has got in the last week from the Goldman deal, it does not look like waiting to go public is hurting Facebook, at least for the moment. In fact, it may be making Facebook an even more desirable investment to those who cannot invest in it right now.
ii. 'Proprietary' information: While I don't think that this is a big factor for Facebook, there are some companies that choose to stay private because they are afraid of revealing proprietary information about their products/services to the general market. Instead, they can provide the information, with sufficient restrictions on disclosure, to a few wealthy investors who can then invest in the company.
iii. Founder idiosyncracies: If the founder and majority stockholder in a company decides that he does not want the company to go public, the company will not go public. In the case of Facebook, it is entirely possible that Mark Zuckerberg has decided that he does not want to take the company public and he does not seem the kind of person who can be dissuaded easily.
iv. Regulatory and information disclosure concerns: From Sarbanes-Oxley to SEC restrictions, public companies are constrained in ways that private businesses are not.
v. No valuation scrutiny: As a publicly traded company, no matter how well regarded it may be, the market valuation will be questioned by skeptical investors. Scaling value to earnings or book value, investors will argue that the company are over priced, relative to other companies in the market. (Take a look at Apple, Google and Netflix, all big winners over the last year, and you will see this phenomenon at play). Facebook gets to have the best of both worlds, again at least for the moment. We get glimpses of its immense value, each time a transaction is made, and no real way to examine whether the value makes sense, since we do not have access to much of the information we need.
In summary, Facebook is in a unique position. It has the profile to raise capital from wealthy investors are favorable terms and is getting many of the benefits of being a publicly traded company without any of the costs. Could that change? Absolutely. If there is bad news (or even rumored bad news) about the company and some or even a few investors have trouble exiting the company, the estimated value could melt down quickly.
(c) How would you value a share in a private company (as opposed to a public company)?
Let's assume that you are one of those lucky investors that has a chance to invest in Facebook. How would you go about valuing the company?
i. Financial data: You have to get your hands on some operating numbers. All you have right now is rumor: Facebook supposedly will generate $ 2 billion in revenues this year and there is no word on how much earnings they will have. You cannot value a company based upon information that is this threadbare and you will need fuller financial statements.
ii. Future projections: Once you have the information, you have to make projections for the future, valuing Facebook just the way you would value any young, high growth publicly traded company. I have a paper on the topic. Normally, with private businesses, you will discount the value for lack of liquidity but I don't think this is a concern with Facebook shares, even if privately held.
iii. Ownership protections: I don't know about you but I just finished watching Social Network, the movie, and I am not sure that I feel secure that my ownership rights will be protected by the controlling stockholders at Facebook. I would need to make sure that there are enough protections in place for existing stockholders in the event of new capital being raised or an IPO.
So, is Facebook worth $ 50 billion? Based upon current revenues of $ 2 billion, it is richly priced; 25 times revenues and god only knows how many times earnings. The justifications that I hear from analysts for the high valuation are:
(a) An unprecedented platform: The 500 million users provide a platform that could generate much higher revenues and earnings in the future, but a lot of things of things have to go right for this to work out. I am not a big user of Facebook, but my gut feeling is that an overt commercialization of the space will make it less attractive to many users. So, it has to be subtle and creative commercialization... while fending off competition. (Remind me again what happened to Myspace, another hot place to be not so long ago).
(b) Goldman knows best: Smart investors (like Goldman) think its worth $ 50 billion. So, it must be worth $ 50 billion. This line of reasoning is so absurd that it is not worth pursuing. If you think that Goldman does not make big valuation mistakes, you are wrong. What Goldman does well is cut its losses, if it does make mistakes. You and I will not have that option.
(c) The Big Story: To those who use the big story justification, everyone will be on a social network in the future, and you need to pay a premium to be part of the movement. Having heard variants of the big story before used to justify other bubbles (dot com, telecomm, PCs), I don't buy this. I think the market may be right about the macro story but is being hopelessly over optimistic about the micro pieces. In other words, we may all be parts of social networks a decade from now, but can all of these social networking platforms (Facebook, Twitter, Groupon...) be profitable? My guess is that there will be a few big winners and lots of losers, before the final story is written. (Remember that the market was right in 1998 about dot-com retailing being the wave of the future but most dot-com retailers never made it through to nirvana. Amazon did and it is worth almost $ 80 billion, but it is the exception.)