A lot of traditional VCs (particularly those based in the West Coast) woke up this morning and tossed some chairs around and broke some really expensive shit because of this article in the Wall Street Journal, lauding Peter Thiel and his partners over at Founders’ Fund, which include Sean Parker, Luke Nosek, Ken Howery. The fund’s investments include:
- Iron Port Systems: email security software (recently sold to Cisco for $830M).
- Slide: the #1 or 2 widgets maker on Facebook.
- Facebook: apparently, a popular social networking site.
- Powerset: the natural search language company launched on the heels of a XEROX patent.
Anyone who has ever read anything on HipMojo.com knows that while I respect VCs, I think the entire industry is one big game of smoke and mirrors. Fred Wilson deserves some credit for introducing transparency to the industry, as does Brad Feld, and a slew of others. While we’re handing out props, TheFunded.com has done a great job of giving some Vulture Capitalists a much deserved public ass-whooping in a fairly open and direct manner, though yes, it has its drawbacks, too. The guys at VentureHacks.com deserve a lot of props for sharing their know-how, because let’s face it, indeed VCs work on term sheets 24/7/365 whereas us hapless entrepreneurs don’t.
But while Wilson and Feld still represent the VC establishment, and TheFunded.com and VentureHacks.com remain outsiders with little direct, material influence; Thiel and his partners in crime are insiders by virtue of being investors, and have a big impact because regardless what any entrepreneur thinks about the value of his or her company, said value is a function of demand and supply… and in an environment where less capital is required to build an empire (and in less time), Thiel’s fund definitely tips the scales in favor of the entrepreneur.
As an entrepreneur, there are no two ways about it: you love what Founders’ Fund is doing, even if they hitherto only invest in limited segments, amongst people they know, and in a specific geographic area.
Moreover, Thiel and Founders’ Fund differs in one more significant way: their track record is actually very impressive, both as investors and operators. Thiel was CEO of Paypal, which we ranked as one of our 13 most explosive startups ever and its acquisition by eBay as one of the best Web M&A deals of all time.
The experiences at Paypal - which has become a GE-like super factory of technology entrepreneurship and investing (in how it has churned out so many founders, investors and managers) - is actually inspiring.
The experiences the men have had individually - such as the rumor that Thiel resents how Mike Moritz pushed Max Levchin’s then-named Confinity to merge with Elon Musk’s X.com to form Paypal and thus dilute his holdings, or pretty much everything pertaining to Sean Parker at either Napster, Plaxo and Facebook, etc. gives them a lot of street cred with entrepreneurs who have grown wary of anything that comes out of a VC’s mouth. You need not read between the lines: I don’t trust VCs, thankfully I’ve not needed VCs to grow WatchMojo.com thus far. While I am not alone thus far, most entrepreneurs don’t have a choice and throw caution into the wind and accept draconian terms.
The main point of objection I have is that it’s not as if VCs - either individually or as a cohesive group - even have an enviable track record. VCs brag about 5 investments crapping out, 2 to 4 being so-so hits, and 1 being a grand slam that makes up for the others. Huh… note to PR team, draft another elevator pitch, pal. I would not brag about taking other people’s money and then sinking 50% of the investment in a toilet… but I digress.
If I have a beef against VCs, it’s not personal; it’s professional. I see through their spin, I can BS better than them, and being a media content oriented company, it’s not traditional VCs that I really count on to find a financial partner. But again, I digress. Technology startups I advise welcome VCs’ interest though I almost view it as a kiss of death (reference Zantaz, Filmloop, and many others).
Anyway, that out of the way… Some gems from the article:
- “Mr. Thiel, the former CEO of online-payment company PayPal, is making waves in Silicon Valley with an investment strategy that differs significantly from the traditional approach. His company invests only modest amounts of money, sometimes just a few hundred thousand dollars, and focuses on entrepreneurs Mr. Thiel and his partners often know personally. He also takes an uncharacteristically hands-off approach to company management.”
- “Many VCs “have these very cushy jobs, they get paid a lot,” and often can’t relate to founders, he says.”
- “Most traditional VC companies want to invest larger sums, several million dollars, say, for large stakes in start-ups and then exert control over the companies’ operations. Some demand “liquidation preferences,” or guaranteed returns if companies are sold.”
- “Significantly, the fund often buys only a 5% or 10% stake in a company and sets up a special class of stock that start-up founders can sell while they are building their companies — and before venture-capital investors see profits. That way, the thinking goes, the company founders can reap some financial reward and stay motivated to build the company before an IPO or company sale, which can take years.”
- “Some traditional investors don’t think founders should make money before backers do, since early paydays might distract them from the task at hand. All of this is causing traditional VC firms to re-examine the way they invest in tiny tech start-ups. VC concerns including Trinity Ventures, for example, are now letting a few of their entrepreneurs “take money off the table” early on by selling stock.”
- “Mr. Thiel acknowledges his company faced resistance from blue-chip investors when it set out to raise money for its latest, $220 million venture-capital fund. One large institutional investor, who declined to be named, said he was put off by Founders Fund’s anti-establishment pitch. Others wonder whether Founders Fund could soon tap out its close-knit network of entrepreneurs and run out of companies to fund.”
I won’t comment on each one, suffice to say it’s refreshing and a welcome change from VC’s draconion rules of engagement in standard term sheets, something I covered recently here. I’ve also long argued that one reason we don’t see any grand slams anymore is because of the greatest mistake VCs and entrepreneurs make, which is not taking any money off the table in financing rounds. What’s that saying? Bulls make money, bears make money, but hogs get slaughtered… yeah, that one.
A cynic would highlight, however, that Founders’ Fund it too young, too early, and too idealistic to have hit some rough patches. In other words, it’s not what Thiel et al. think and do now in good times, but how they will react in a downturn. Judging by many economic indicators, the economy won’t be spectacular in 2008, but as we’ve outlined before, that will actually help the Web sub-economy in a few ways.
To conclude, Founders’ Fund won’t even be the biggest wave to shake down VCs in the US. That, my friends, will be foreign capital, trickling in more and more in 2008 and flooding American startups in 2009 and beyond. Foreign financial institutions - be it in China, Singapore, Saudi Arabia, etc. - are investing 5-10% in American financial giants. Over time, the same trends will lead many investors to start to invest in US startups as well. For more on this, see our sister publication WorldMojo.com’s post World to USA: Who’s Your Daddy?.
To estimate how much a company is worth, you can look at:
1- comparables amongst publicly traded companies
2- recent merger and acquisition deals
3- estimate its future earning power, discounted to today
4- forecast what an asset would fetch in an auction or sale, be it in an M&A or an IPO.
Dave Winer yesterday asked how much is Facebook worth but did not answer the question. We’ll attempt to do that.
Clearly when it comes to guesstimating Facebook’s market value, it’s not that clear, or easy. But ultimately, the only thing that matters is “Is Facebook for sale now?”
Facebook will ultimately be sold, either to the public capital market or to another company. Let’s hold off in the IPO route and see what we can derive in each one of those methods:
1- comparables amongst publicly traded companies
There are not any real publicly traded social networking sites, so we’ll simply look at the leaders online: GOOG and YHOO are pure play web companies. GOOG trades at a Price/Sales of 14, YHOO at a P/S of 6. Their average is 10, so if according to Facebook investor Jim Breyer of Accel Partners Facebook makes $100M in revenues, that means Facebook is worth $1B. We won’t apply a liquidity discount in this case, because Facebook is no startup, even though its revenue diversification and pipeline might suggest that it is.
2- recent merger and acquisition deals
Recent high profile deals on the Web such as aQuantive and Doubleclick have fetched as much as 30 times revenue. Using that metric, Facebook is now worth $3B. Of course, comparing a social network with abysmal click through rates (CTR) with an online advertising media services and software company respectively is a crime. Yes, Facebook is growing rapidly, but its monetization - or lack thereof - implies that using a 30 times P/S multiple is a dangerous thing to do for an acquirer.
The only other M&A comparable, obviously, is MySpace. MySpace was owned by Intermix, who got $580M by News Corp. For simplicity, we’ll project the entire value of Intermix onto MySpace (we don’t think News Corp. would have bought Intermix otherwise, in other words).
At the purchase date, MySpace had 22M members and 15M uniques per month, today two years later it has 100M members and 70M uniques and is larger than Facebook. I’ve said that in 2008 Facebook’s growth suggests it will be larger than News Corp.’s MySpace, but that’s just me running wild in Excel.
Today MySpace can claim to have a valuation of $5 to $10B. The former is a fair, arms’ length valuation by many, the latter is Rupert Murdoch trying to heist 25% of Yahoo!
The point is, MySpace is larger, it’s part of an established media empire now, so just because one thinks that Facebook is a more attractive dame does not make it a more valuable enterprise. Since being acquired, MySpace has tripled in size, YouTube’s been acquired for $1.65B (providing an additional recent M&A comparable), so it’s easy to argue that MySpace is arguably worth $2-3B. Is it worth $5B? $10B? I’d say no, but seeing it become the largest site online when measured by pageviews at least gives Mr. Murdoch’s argument that it’s worth a lot plausible. Of course, just last year, he said MySpace was worth $6B, yet one month ago when trying to parlay his asset into a 25% share of Yahoo! implied a $10B valuation. I’d say Mr. Murdoch was showing his usual brazen dealmaking style and not accurately reflecting MySpace’s value.
The point we’re trying to make is that if YouTube fetched $1.65B last year and MySpace has tripled and is in the $2-3B range at most, then by this formula Facebook cannot possibly be worth more than $2B. For what it’s worth, Yahoo! offered $1.62B as late as October 2006.
3- estimate its future earning power, discounted to today.
The discounted cash flow model (DCM) is a theoretical formula that looks at constant growth companies’ future earning power to derive a present value. Of course, Facebook - whose unique audience grew from 21.8% from April 2007 to May 2007 - is anything but constant growth.
But that’s in audience. Its revenues, while growing, are not necessarily sustainable. I’ve covered that in points 3 and 4 of Facebook’s To do List in 2008: IPO. Briefly: MSFT is paying it an annual fee and I doubt it is seeing a positive return on its investment. Translation: no guarantee MSFT would renew, and sure, maybe Google would come in its place, but after agreeing to pay $900M over 45 months for MySpace (where I argued it might have overpaid) I wonder if lightning would strike twice for social networking plays striking it reach via Google.
A note on what could make Facebook money
Of course, it is plausible to argue that Facebook’s holy grail will come not in display banners or text links but something else.
Naturally, as we slide down the spectrum from CPM to CPC, one asks: will Facebook become the CPA king.
Briefly, CPA stands for cost per action, or sale, whereby the publisher gets a cut of a transaction when a user clicks through and purchases a good or service from a merchant or advertiser. For a complete look at web advertising definitions and terminology click here.
The argument for Facebook and the CPA brass ring theory is that if Facebook is the database of connections, then we would value one another’s recommendations and this would lead to a lot of transactional commerce whereby Facebook could, through sheer numbers and volume, make billions of dollars.
Maybe. Maybe not. It’s all a big theory right now. The problem here is, when people are urging others to add them as friends and what not, I don’t think one puts a lot of weight on the recommendations people make. For the record, I’m not criticizing the people who do that, we’re in high school again, I guess, but it does make the value of “connections and relationships” built in such a way go down the drain, quickly. Similarly, the value of any recommendations for products and services do steadfastly.
If suddenly people on Facebook have an incentive (think Ad Sense for Publishers but tweaked to pay out a portion of Facebook’s bounty to its users) then we start to recommend things we don’t actually like. This happened when publishers began to create “empty calorie” pages on high CPC keywords to generate more revenue.
4- forecast what an asset would fetch in an auction
Finally, the time-tested answer to “how much is something worth” is “whatever someone will pay for it”. In other words, the greater fool theory applies to private and publicly traded assets. Here, we know that Facebook’s Speculative Value (in other words: rumored) has risen from $800M to $10B just yesterday.
Rundown of Rumored Bids for Facebook:
Spike in Speculative Value:
That is folly. Here’s why:
Very few companies have the ability (cash and balance sheet) to make that happen. Let’s look at just a few of the usual suspects:
Let’s first state that any M&A deal for Facebook would be cash-based. I’m not sure Google stock is something that a seller of Facebook equity would welcome (if it were restricted - more on this below). Google offered Friendster a sum ages ago that today would be worth $1B. But, that was when Google itself was private; we know that pre-IPO stock is valuable, post-IPO usually less… and quintupled stock price after the IPO price even less so.
Why A Google Bid is Unlikely
People frequently think that Google will buy Facebook, but the problem is that Google today has about $10B of cash on hand (after you add the $1.5B it has added from operations in 2007 and the $3.1B it has earmarked for DCLK).
Sure, it can sell more shares in a secondary offering, and at a high of $500+/share, maybe Sequoia, Kleiner Perkins and the Google co-founders would sell $5B worth of shares or so to bolster their warchest for a run at Facebook, but those are a lot of “if’s and maybe’s” and until they do so, they are not really in the running to do so.
Then again, Google can always make a stock-based deal for Facebook with unrestricted shares which would allow Facebook shareholders to sell as many shares at any time. But, I personally doubt Facebook’s shareholders would swap ”cash in hand for shares in the bush”.
As well, I doubt Google would want that, because if Facebook shareholders decide to sell the shares en masse, that would put a considerable downward pressure on Google stock. Sure, at a market cap of $165B, paying something like $5B for Facebook means that it’s a drop in the bucket (didn’t we say the same thing about YouTube and its $1.65B price tag… drops add up, you know).
But, if Google shareholders know that Facebook shareholders got unrestricted shares and will start to sell, causing downward pressure, then the domino effect would entail Google shareholders to sell too. That is one slippery slope than could institutional investors, Google investors, Facebook investors and many individual shareholders to sell their shares and send Google tumbling down, because everyone will want to buy the shares back later at a lower cost. Google’s army of PhD’s have probably thought about this… at least I hope.
In this context: only MSFT and News Corp. have the wherewithal to pull the trigger, unless you think Google will part with 60% of its cash for Facebook, which is unlikely.
Why a News Corp. Bid is Unlikely
I doubt News Corp. will, especially if they plunk down $5B for Dow Jones, which looks increasingly like a fait accompli. Even though that deal will be cash and stock-based, I doubt Rupert Murdoch will have the appetite to part with much of his $7B cash hoard and dilute that much to existing Dow Jones and Facebook shareholders…
Of course, the problem lies in the fact that while the former is a monetizable asset, the latter less so, especially when News Corp. has its hand full with trying to monetize MySpace. All of FIM might generate $500M in revenues for News Corp., but that includes IGN and FOX’s legacy websites (FOXSports.com, American Idol, etc.) and accounts the $25M/monthly amount Google pays it, so as you can see, News Corp.’s digital dreams are still largely aspirational and a mere mirage.
The case for MSFT
Proponents of the MSFT-Facebook argument state that MSFT has proven that it would consider and has done a large web deal: that of AQNT (disclaimer: I owned AQNT up to yesterday). Of course, it’s one thing to pay $6B for an online advertising services company founded in 1996 and based in Seattle that made $400M in revenues and another thing to pay anything remotely close to that for SF-based Facebook which generates $100M largely from Microsoft and is being sued by ConnectU.com for the fact that Mark Zuckerberg allegedly stole the source code for their project from them. In other words, if it’s true that Zuckerberg did such a thing, it would give pause to anyone who would remit a multi-billion payoff to him and sign some form of employment and non-competition agreement. Yes, I know, non-competes are “useless” in California…
But the main argument is: this all boils down to “is Facebook for sale” before it does an IPO. Sure, Peter Thiel threw out a $6B figure, but if you read that properly, he said by 2015, if you look at MTV, Facebook can be worth $6B. The press omits that and runs with it. Just yesterday Jim Breyer said that any deal would have to be at least $1B. In other words, while we wish the Facebook shareholders nothing but the best, but Facebook is not worth $10B, let alone $6B because ultimately:
- very few companies can pay that (GE won’t pay anything near that for DJ, an actual business, to defend its profitable CNBC franchise, so let’s not pretend it would pay anything material for Facebook);
- very few companies can ever make money off of Facebook. In theory, everyone can make billions, but social networking is a crapshoot.
In fact, on the monetization front, up to 2002 or so, Google still had no clue about how to make money. It looked at Bill Gross’ model for Overture (disclaimer: in 2000 I worked for Mamma.com, a meta search engine, and we were then too running text ads alongside the organic results). It then bought Applied Semantics in 2003 for the contextual text link technology, bought out the only indirect competitor for that Sprinks from About.com, shut it down, and then leveraged its search engine traffic and superior content-matching text links to become the Web’s billboard champion on a CPC-basis. But even then, it was not Sergey Brin or Larry Page who executed that, it was Omid Kordestani - former sales executive at Netscape and Stanford alumni - who made the plan go from concept to reality.
The bottom line: sure, Facebook looks at the exponential growth of MySpace and says “why sell”. They’ll also look at Google’s rejection of Yahoo!’s $1B offer and wonder “what could be”. But when the dust settles and the buzz wears off, they understand that even an IPO will fail to maximize their investment. Here’s why.
The IPO is No Guarantee
When a company goes public, shareholders do not sell their entire shareholdings. That is why the Google co-founders are worth $16B each when they were worth $5B or so when Google went public. Sequoia’s Michael Moritz in fact sold nothing at the IPO when the Dutch-auction priced Google shares at $85 in lieu of $100.
The point I am making is even if Facebook can leverage demand and get a very high price for its shares upon its initial public offering, devoid of anything other than MSFT’s prized deal, it will not show the kind of revenue and profit profile that investors will want for a company with a valuation in the $2B to $10B range. CNET (yes, its traffic is falling) is worth $1B. Yahoo! and its $6B in revenues is worth $35B. Amazon.com is worth $30B…
To conclude:
Run down the list and you will see that at present time, the best answer for Facebook’s shareholders remains a sale in the $2-5B range if they can get that. That is why MSFT need not even contemplate going as high as $10B: Zuckerberg and Facebook shareholders are smart. They know that sure, in a crazy, crazy world, they can ask for the moon… but there are few actual takers out there, and since MSFT remains the only company with the financial firepower to make this happen, they can stop the bidding at $6B… and even then, the better question is: is Facebook worth that much?
Well, what was that about “the time tested answer to how much something is worth is…”
I previously said that relying strictly on human psychology: if Zuckerberg indeed owns 30% of Facebook, a deal at $3.33B would get the job done because he’ll pocket $1B. At 23 - or any age - it would be very hard to say no to that.
Of course, since $3.33B is within striking distance of many firms (technically, Yahoo!, Google, News Corp., Microsoft), then the price could move up. That is what happened with Doubleclick, I believe. The problem is even for Yahoo!, this means selling shares, and at a $26/share range, it would mean “sell low, buy [Facebook] high” [Disclaimer: I own shares in Yahoo!].
So when the dust settles, given all the variables:
- the low range for a deal is $3.33B
- the high range is $6B.
To answer a reader email: Clearly, this assumes everything continues as is for Facebook, we know that is not the case. I personally don’t even find Facebook all that useful. It’s “neat” to reconnect with former classmates, but ask yourself why you never kept in touch with the majority of classmates in the first place. This is an analysis very much set in the context of the hysteria surrounding Facebook and not a statement that in 6, 12 or 24 months, Facebook will be a coup. We’ve seen advertisers not getting much value from Facebook, in start contrast to Google. As such, if Google is worth what it is, it’s not because it’s neat, it’s because it is an effective ad platform.
Regardless, even in the context of such mania, these are very expensive prices from any traditional metric: 33 to 60 times revenues… but of course, this is a sought-after asset. To clarify, I’m not saying Facebook deserves to be worth so and so, I’m just saying that if ultimately an asset is worth what someone will come along and pay for it… then once you go through all of the dynamics and variables, this is a reasonable range… it does not mean that anyone will come along and pay that.
Any thoughts?
Disclaimer: I could be wrong, very wrong, of course…
PLAY
