Facebook’s Valuation Problem

The WSJ recently reported that Microsoft is sniffing around Facebook, less than seven months after investing $240 million in the social network at a $15 billion valuation. It was largely discounted as the hopeful fumblings of Steve Ballmer, in his search for a rebound acquisition after being dumped by Yahoo. But it got me to thinking: Microsoft’s initial investment may be one of the worst venture capital deals of all time.

Longtime readers know that the current title-holder is Hummer Winblad, for its Napster investment in the midst of that company’s legal morass. And it will remain that way, as Microsoft’s Facebook deal presents neither the legal difficulties nor the likelihood of a total write-down. In fact, it’s probably been a good strategic deal for Microsoft, which doesn’t need to sweat the small stuff (i.e., cash). The only caveat to that last part is that Microsoft is now expected to overpay for all its other acquisitions, which has led to a trickle-down throughout the Web 2.0 market. For example, macro valuation inflation helped scuttle the Internet roll-up envisioned by Ross Levensohn and Jon Miller — as their targets upped their respective asking prices.

Anyway, back to my thesis. The reason this might be one of the worst VC deals is that all of its negatives fall on its supposed beneficiary: Facebook.

This isn’t a dilution argument, but rather one of public perception. Social networks partially work because of functionality, and partially because of bandwagon popularity. You don’t necessarily join and use Facebook because it works well, but perhaps because your friends have joined and use it. And, as has been proven with MySpace-Facebook-Beebo, that usage can be fickle and prone to migration.

Public perception is very important, and I think the Microsoft investment has set Facebook up for a giant egg pie in the face. For example, imagine the endgame is to go public. If so, there is no way a company with such low revenue could possibly get near a $15 billion valuation (this isn’t 1999, and Facebook isn’t Google circa 2004).

So let’s generously imagine it could get $5 billion. Know what the headline will be? How about: “Facebook Files for IPO.” Looks good, but check the subhead: “Social networking company worth just one-third of 2007 valuation.”

Ditto for an acquisition, as no company in its right mind would pay close to $15 billion for Facebook. Yes, that includes Microsoft.

What this means is that Facebook is going to lose heat upon liquidity, and a loss of heat can lead to a loss of cachet. Remember all the buzz when Facebook got the $15 billion? Now imagine it again, but with a negative spin (particularly outside the TechMeme bubble, where most of Facebook’s users actually live).

All of this is exacerbated by the fact that Facebook never really needed to take the Microsoft money (could have gotten it elsewhere), and certainly didn’t need to confirm the valuation in a press release.

The only out I see for Facebook is to take another big strategic investment at the $15 billion figure. It could provide liquidity for Facebook’s early VCs like Accel (whose LPs would really like some payoff) and other employees looking to turn their paper green. And, yes, that probably means Microsoft again. If not, that original investment will hurt Facebook far more than it will help it.

Note: Much of the above argument was first made (to my ears) by venture capitalist Stewart Alsop, at this year’s VC in the Rockies conference. It took my a while to come around, but I’m now there. Hope he doesn’t mind the pilfering.

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20 Comments

  • The implicit argument seems to be that Facebook would have been better off raising no money or raising money at a lower valuation. First, given the amount of activity in the social networking / Web 2.0 area, I believe it was absolutely prudent to have a relatively large amount of cash on hand. When compared to major competitors (Google, News / MySpace, Yahoo, MSFT) this is actually very little cash. As far as the valuation, I think the public perception idea is a little overblown. There may be a certain negative stigma should Facebook file for an IPO at a lower valuation. But would avoiding the stigma really be worth substantially more dilution for the founders and earlier investors? Institutional investors tend to have short-term memory so any stories about an old financing would likely quickly be subsumed by the public market trading activity. Also, only a small percentage of Facebook users seem to follow the company’s financing (or care).

    A larger concern could be any preferences that might make any exit below $15 billion unacceptable for anyone but MSFT. This could create tremendous conflict between shareholder classes. However, Facebook’s VCs are pretty sharp and I suspect that they have already thought through these issues.

  • I disagree with your argument that “you don’t necessarily join and use Facebook because it works well.” Many of my friends and I have migrated from Myspace to Facebook for the very reason that Facebook works better than Myspace, which is prone to technical glitches when trying to load a page. Yes, my friends and I are a very, very small number of users, but I have talked to other people who have started to use Facebook more than Myspace because of the same reason: Facebook works better.

  • [...] banniNation.com wrote an interesting post today on Facebook’s Valuation Problem [PE HUB]Here’s a quick excerptThe WSJ recently reported that Microsoft is sniffing around Facebook, less than seven months after investing $240 million in the social network at a [...]

  • what struck me as self-defeating in the public announcement of
    valuation was that setting the fair-market value of any subsequent
    option disbursements (Section 409A) must’ve caused every
    additional employee to come in with a “start up” strike price of
    at least north of $10. one could argue that it would be difficult
    to recruit clueful people if Facebook truly set the price as they
    should.

  • [...] | Share on Facebook | Del.icio.us | Digg this | Email This | Print Read more: Global Post a Comment Name: [...]

  • To my knowledge no one ever took this deal apart to figure out what Microsoft was getting for its money. Hidden in plain site was the fact that it also got an advertising deal, extending an earlier arrangement that had been in place for a year. There’s a reasonable argument that MSFT paid $120M for an advertising deal and $120M for a small equity stake, which puts Facebook’s valuation at half what others claimed Facebook’s valuation was. If you want, you can say that the deal valued Facebook at only $1B, depending on how you play with the numbers. Net net: don’t use the MSFT investment as a reliable guide to what Facebook is worth.

  • Agree with Paul the valuation is false. Further, the investment is more like a loan as it preferred stock. You might say there is a strategic acquisition premium to get the advertising deal as Microsoft desperately needs to build an advertising sales channel before their cash cow products get commoditized.

    Finally, I will point out that HumWin’s mistake was not the investment, but in taking operational control of a company that was breaking the law and then continuing to break the law. Further the HumWin partner who became Napster CEO was a very experienced valley lawyer.

  • Two points:

    (i) This has been known awhile, it just was an unpopular view once :) – we blogged it here last October:

    http://broadstuff.com/archives/484-What-you-have-to-believe-to-value-Facebook-at-15bn.html

    (ii) *That* Henry Blodgett disagrees with you – Do I hear deja vu 2.0 ;-)

  • “Cachet” not “cache”

  • I don’t want to say “told you so”. But oh heck, told you so (vintage July 2007, top of the hype cycle):

    http://bernardlunn.wordpress.com/2007/07/23/the-facebook-bear-case/

    It was much more fun when this stuff was public and we could trade it to make some easy money!

  • thanks for the eagle eyes owen. it’s fixed.

  • dan-

    your logic presumes:
    a) avg facebook user gives a crap about valuation
    b) limited future FB growth
    c) no future improvement in monetization, &
    d) the need to go public anytime soon

    all of which are arguably, if not demonstrably, quite incorrect.

    it may take time for them to grow into/past the current valuation, but its certainly not impossible within 2-3 years, even if monetization doesnt improve much… and quite probable if it does.

    my $15b & .02 cents,

  • [...] Dan Primack at peHUB argues that MicrosoftÂ’s initial investment in Facebook may be one of the worst venture capital deals of all timeÂ…Maney on the oxymoron that is Microsoft innovationÂ…Portfolio.com’s Felix Salmon discovers that Citigroup’s retail banking operations in Germany really are non-coreÂ…From McSweeneyÂ’s: “Word problems for future hedge-fund managers.” Â…It has been Resolved: The U.S. is the New Third World. (See this post from Paul Kedrosky at Infectious Greed. No, he is not arguing this — rather three recent articles are.) [...]

  • So…I love these posts where people make statements they probably arent qualified to…I would be curious to hear what the author has to say about the $1.65B for YouTube…where the investors there stupid or naive? Do you think the hindsight of history is helping you to try to sound smart? Napster was (and probably still holds the record) the fasted growing company in internet history…and it had the same risks as YouTube…

  • Aces,

    1. YouTube did not hold the same risks as Napster. The former had the potential for copyright litigation, but most of its content was user-generated. Napster, on the other hand, was already in the midst of serious litigation. More importantly (as a commenter noted), Hummer Winblad did not just invest in Napster, they virtually took control by installing one of their partners as CEO. It was a bad risk to take.

    2. You’re mixing apples and oranges on the valuation issue. The VCs did not value YouTube at $1.65b — that’s what they sold it for. And, as I’ve said before, I don’t think that the $15b valuation was necessarily bad for the investors. I think it’s bad for the company.

  • At what tipping point do we accept the adage, “it is what it is”? WIth all the crazy valuations springing up in Silicon Valley, you have to wonder whether the “logical” and “rightful” outcomes have any chance of coming into fruition. As long as there are those who buy into the hype, when does it stop becoming hype and becomes reality instead?

  • I think Dan may have been proven right by the news that FB raised $100m in debt. It officially didn’t take it in equity because of dilution, but there wouldn’t be much at a $15b valuation. That means it basically couldn’t get anyone new to come it at that number.

  • Dan,

    Your post makes valid points, but I think the core statement that “Microsoft’s initial investment may be one of the worst venture capital deals of all time” is flawed. Microsoft’s $240 investment is not a venture capital investment. It is a strategic corporate investment. Microsoft is not a VC and doesn’t care about the IRR or multiples from the financial point of view. We’ll wait and see what the strategic value turns out to be, but I think it is already bearing fruit given the Yahoo imbroglio.

    Now, if you’re saying that this investment is one of the worst corporate investments of all time you need to compare it to eBay-Skype, Time Warner – AOL, et al.

  • [...] The bad news is if FB was able to sustain a $15bn valuation you would always go for the tiny dilution that would represent rather than saddle the company with debt of any kind. It suggests to me that nobody was willing to pony up $100m for 0.67% of the share capital, not even investors who had previously invested at that level. To that extent I agree with Primack that the high valuation has hurt FB. With equity funds apparently cut off without climbing down from the big 15 it is now effectively forced into borrowing until it finds a viable revenue model. I strongly doubt the size of the pool willing to lend. With the credit crunch happening few banks would lend to FB at all and those that did would only do so at a punishing interest rate – perhaps calculating that if the worst came to the worst Microsoft would ride to the rescue and pump in more cash having shown considerable willingness to do so in the past. I don’t think TriplePoint is being any more generous. [...]

  • [...] this week have questioned the value implied by Microsoft’s Facebook deal. On Friday, PEHub’s Dan Primack suggested it might be “one of the worst venture capital deals of all [...]

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