Tuesday, January 11, 2011

Did Goldman Overpay for Its Facebook Stake?

It's the spring final exam in an advanced corporate-finance class on the campus at Darden. Or Tuck. Or Stern, Texas, or Emory. The professor distributes the exam. The students wince and are befuddled, because the exam has only a few questions with several parts. There are no numbers, equations, spreadsheets, models, or formulas. Just questions that require thought, analysis and maybe follow-up. How would you handle them below?

1. What is the true value of Facebook? How would you value it? What is its value today? Is the true value above or below the reported $50 billion?

What would be its value in two years? In five years?

2. Did Goldman Sachs overpay for its recent $450 million stake? How did Goldman reach its implied $50 billion value--from expectations about cash flow and earnings? From comparing Facebook to current market values of Google and Microsoft? From examining the acquisition values of other Internet companies in recent years (if there were any of note)?

Or from its willingness to pay a premium above a real value in order to gain an inside track to the heart of the company?

3. What really is the primary purpose of Goldman's investment?

If it were a ploy to race to the front of bankers' efforts to win the mandate to lead Facebook's possible IPO and become its primary investment bank, is the investment worth the risk for Goldman?

4. Why was Goldman willing to tread close to legal boundaries governing investments in private companies by setting up a separate special-purpose vehicle to permit some of its private clients to invest as much as $1 billion or more in total in Facebook?

5. Why would its affiliate Goldman Sachs Capital Partners, a private-equity fund managed by a different Goldman unit, reject the opportunity to invest in Facebook? Why would the view of the value and opportunity in Facebook differ in two different parts of the same firm?

Are there potential conflicts when one side of an investment bank says yes and another says no to the same investment opportunity?

6. What impact would the recent $50 billion valuation of Facebook have on the current implied values of other private social-network sites such as Linkedin and Twitter?
7. What are reasons Facebook agreed to accept new cash capital (new funds)? Was there a short-term cash need?
Did it require funding to support long-term assets, investments or possible acquisitions? Is it adding to infrastructure to be able to accommodate over 1 billion in users?

Perhaps most important (and perhaps beyond the purview of a finance exam): With a growing number of investors at the board table, is the vision of Facebook fashioned by its CEO Mark Zuckerberg at risk of being undermined in a way that makes him and his fellow visionaries uncomfortable?

The "exam" above probably couldn't be tackled in two hours. That wouldn't be fair to students. It might entail an entire course on its own in a semester. In many instances, there are no right or wrong answers. There likely isn't even a right or wrong value of the firm at this point. It would be better if the professor from Darden (or Marshall, Tepper, or Haas) presided over a lively, probing discussion of the "value of the firm" instead of requiring students to compute an exact figure--although the real world of finance forces investors, traders and market-watchers to determine a precise number every moment markets are open.
There are challenges in determining that precise figure. The first is the lack of data and the lack of reliable financial information about past and expected performance--given the current infrastructure, funding needs and expected growth.

The second is the complexity of valuing new organizations, especially Internet companies with little earnings record, with novel business models and with a reliance on clicks and eyeballs to generate advertising revenue. Is "value" achieved from expectations of cash flow five years from now? Is "value" achieved from the aggregation of hundreds of millions users? Or will "value" be achieved if and when the company is acquired by another firm and integrated into a larger, complementary business (Google? Microsoft? Viacom?)?

The third challenge might be the pitfalls of valuing "hot" companies based on a swoon of widespread popularity and buzz and the possibility that the hot fad will dim or be canceled out by next year's new model, fad or Internet wonder. (Whatever happened to buzz and popularity of MySpace.com?)

Goldman and team, of course, had access to real data. More data have been seeping out in recent days, as Goldman prepares its offering of investments in Facebook for its client base (via the special-purpose vehicle).

By now, many who watch Facebook's every step are aware the company now has over 500 million "members" or "accounts," generates over $2 billion in revenues and probably has annual earnings in the $200-$500 million range (depending on who's estimating, who's modeling, or whose accounting methods). While Facebook's market value is being reported at or near $50 billion, its "book value" is probably significantly lower--perhaps much less than $2 billion, if anywhere near that.
With plans to continue accelerating momentum, grow and create more uses for users (more reasons for people to spend more time on the site), Facebook probably needs Goldman's cash investment (including the $1 billion-plus from private clients). The infrastructure needs to be supported; new servers must be added, and employees must be paid, as the current flow of revenues might not always keep up with expansion (at least for now).

So why would Goldman and team pay over 100x current earnings for its stake?
If the valuation has an implied growth rate, is this growth realistic? Does the implied growth rate require Facebook to reach over 2 billion accounts in five years? Does it imply the company will successfully expand into countries where it hasn't penetrated yet (Japan, China)? Does it imply the company will continue to unveil new purposes for Facebook and will summarily resolve all issues or concerns related to privacy?

In Goldman-like fashion, as it sought a new long-term client, it determined it needed to do whatever possible (by taking reasonable risks, not absurd risks) to be the first big bank inside and to do so by being all things at once--investor, financial adviser, broker, strategic adviser, and (and when those times come) lender, private-client adviser, block trader and underwriter. If that is its goal (and not neccessarily doubling its $450 million investment), then the investment will likely be worth the risks and will reap long-term rewards more than what a potential over-priced investment could.

There are non-financial risks, nonetheless: (a) the risks that it will encounter legal issues from a new interpretation of the rules that govern the maximum number of investors in a private enterprise; (b) the risks of perception that one unit of Goldman rejected an investment opportunity that another embraced; (c) the risks of perception that Goldman is facilitating lucrative, home-run investment opportunities for the "super rich," those who qualify to invest in the $1 billion SPV fund. In Goldman fashion, these kinds of risks were probably vetted thoroughly, if not resolved.

Meanwhile, Zuckerberg and team, however, must now contend with how to stay true, steadfast and stubborn to the original vision. Will the Facebook we see in 3-5 years reflect what its creators envision today? Will it be a product shaped by the intents and objectives of institutional investors seeking a 15% return on equity every quarter? Will Google, Microsoft, and/or Goldman be calling the shots? (Or will Facebook be calling Google's shots?)
Or will the next new thing have come along and the world flees to that?
Tracy Williams

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