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.