Tuesday, 11 January 2011 20:05

Facebook Registers The WHOLE WORLD! Or At Least They Would Have To In Order To Justify Goldman's Pricing: Here's What $2 Billion Or So Worth Of Goldman HNW Clients Probably Wish They Read This Time Last Week!

This is the Facebook valuation exercise that I promised to release to the professional (HNW) blog subscribers (File Icon FB note final). As is customary, I am including a material amount for the public blog to chew on. I think most will find it quite the engaging read, at the very least. If you haven't read my first three pieces on this topic, please do so for you will easily be able to glean my overarching opinion on this most recent Facebook "investment":

  1. Facebook Becomes One Of The Most Highly Valued Media Companies In The World Thanks To Goldman, & Its Still Private!
  2. Here’s A Look At What The Goldman FaceBook Fund Will Look Like As It Ignores The SEC & Peddles Private Shares To The Public Without Full Disclosure
  3. The Anatomy Of The Record Bonus Pool As The Foregone Conclusion: We Plug The Numbers From Goldman’s Facebook Fund Marketing Brochure Into Our Models

As reported by Bloomberg, the Facebook stock sale throws new light on the Goldman Sachs potential conflicts of interest – conflicts which we have illustrated in full detail in the past. By offering shares to its most favored clients and forcing them to commit or decline in less than a week, Goldman not only made investing in Facebook seem like a precious privilege from a marketing perspective, but made due diligence nearly impossible for those who did not have a dedicated staff with the free resources to throw at the problem in near real time. We, at BoomBustBlog would like to remedy such an issue as what I see is the new face of  investigative reporting and analysis on the web, and will offer consulting services to HNW and UHNW clients who find themselves in similar binds in the future. Simply drop us an email.

Goldman warns, 'We’re probably going to dump this load, but we may also need you to remain behind to hold the bag!'

In its offer for the $1.5bn stock sale of privately held social-networking company Facebook, Goldman Sachs disclosed that it might sell or hedge its own $375m investment without warning clients. Under the deal, private wealth-management clients would be subject to “significant restrictions” limiting their ability to sell stakes while Goldman Sachs own holding can be sold or hedged at any time, and without warning. One would hope that astute clients and investors would be put on guard by such conflicting and restrictive liquidity measures! In addition, it appears as if Goldman Sachs failed to disclose its clients that it had offered Facebook shares to its internal investment group, Goldman Sachs Capital Partners, headed by one of its star fund managers, Richard A. Friedman.

Since 1992, GSCP has invested its own balance sheet as a principal (that is, on behalf of Goldman itself and its employees) in private equity and has leveraged that investment through funds raised from its institutional clients which include pension fundsinsurance companiesendowmentsfund of fundshigh net worth individuals, and sovereign wealth funds. Unlike most of its (and Wall Street’s) client orientated investment funds, this vehicle actually puts a significant amount of Goldman’s skin in the game (see Even With Clawbacks, the House Always Wins in Private Equity Funds for an example of the implicit call option private equity investors give these fund managers, absolutely free, and the perverse incentive to do deals regardless of the investment outcome that the options create). The most recent vehicle, GS Capital Partners VI, closed with $20 billion in committed capital, $11 billion from institutional/high net worth investors and $9 billion from Goldman Sachs and its employees. That breaks down to a 55:45 split, much too rich a contribution from the GS side in order for them to play the games detailed in Even With Clawbacks, the House Always Wins in Private Equity Funds. Thus BoomBustBloggers should take note that GS Capital Partners VI is the current primary investment vehicle for Goldman Sachs to make large, privately negotiated equity investments in which they are serious about actually making investment gains in, versus churning and overpricing in the attempt to generate fees and bulge the bonus pool.

With this backgrounder in mind, be aware that GS Capital Partners rejected the Facebook deal as inappropriate for its clients (its clients being 45% Goldman employees and Goldman’s own balance sheet girded for longer term principal investment), in part due to valuation concerns. Mr. Friedman apparently has the very same valuation concerns that Reggie Middleton and BoomBustBlog hold.

Goldman attempts to circumvent SEC policy, or clearly signals that Facebook is to issue an IPO – or both!

The special-purpose vehicle (SPV) created by Goldman Sachs is yet another demonstration of how the firm is giving  the impression that it is skirting SEC regulations. The SPV is intended to pool several investors' money into single investment vehicle to create the legal effect of a single shareholder as each SPV is counted as single shareholder despite several thousands of investors participating in the vehicle. The SPV is an attempt by GS to skirt securities regulations that require any company with more than 499 investors to meet SEC reporting requirements. According to the private-placement document, Facebook plans to increase its number of shareholders above 500 this year which would force the social-networking company to begin disclosing reams of financial information or go public by April 2012.

Facebook:  Is it just a fad? Online social trends are completely unpredictable. If a new trend comes along that would start engaging people, then Facebook could become the old way of social networking just as quickly as it became the new way (if not quicker). It’s not as if it hasn’t happened already, ex. AOL, MySpace, Orkut and Hi5. Facebook does have an advantage that its predecessors didn’t in that they attempted to create barriers to entry for competitors with the “Facebook connect” api (application programming interface) that allows for sites across the web to authenticate through Facebooks user community rather than have a user type in repetitive login usernames and passwords. While this is an advantage in that it offers some barrier and is quite popular, it is not an insurmountable barrier for if the tide changes, all users need to do is enter one more username and password combo to switch over to another platform.

A high profile IPO commanding a premium valuation before the trend fades away is the best way to create excess proceeds from retail investors. We don’t believe that the Goldman Sach's investment materialized to meet Facebook’s opex or capex requirements. The whole idea behind the investment was to set a ground floor for a “knock ‘em out of the ballpark” valuation in the eventuality of IPO and put Goldman Sachs as a front runner candidate to manage IPO. An IPO of that order would mean that Goldman has a chance to collect significant investment banking fees which typically range between 4-5% of the size of a flotation and to take part in windfall profits during a (successful) IPO. With its $450m investment, Goldman Sachs would own 0.8% stake in Facebook while Digital Sky Technologies with $50m investment alongside its previous stake would end up with c10% stake.

Although, Facebook has lot of potential opportunities and is yet to fully address (it has begun to implement some of the following) several markets including mobile-ad market, ads on partner sites, the launch of e-mail and location features, one has to remember before paying a 100x PE multiple that the despite its cult monopoly status, as an operator of a social networking site, Facebook operates in a highly vulnerable, highly volatile market that is quite susceptible to changing social trends. From AOL, to MySpace, to Twitter, to Yahoo to Facebook, we have sign roaring fires and spectacular flameouts, sometimes within the span of just a couple of years.

Facebook: A great social networking site for users but does it translate for advertisers?

Social networking websites are a great place to make new friends and interact with old ones. However, from a revenue perspective they have been lagging. People log into social networking websites to interact with their friends and play online games, and its members as such appear indifferent to advertising. According to industry sources, Facebook click-through-advertising rates (CTR) are much lower than Google and Yahoo, and even lower than its social networking peers, MySpace. Google has CTR of 8% while MySpace's has CTR is about 0.1%. Facebook on comparison has just 0.04% CTR. Explanations for Facebook's low CTR include the fact that Facebook's users are more technically savvy youngsters and are better at ignoring advertisements. On MySpace users spend more time browsing through content. While on Facebook, users spend their time communicating with friends hence, diverting their attention from advertisements. However, Facebook fares much better in video content. According to a study, it was found that for video advertisements on Facebook, over 40% of users viewed the entire video compared with 25% for the industry average.

In addition, Facebook’s low CTR belies its best in category reach, which compensates for the lower CTR. This is both a blessing and a curse. Althouth the raw money does manifest from the larger numbers, the fleeting and ephemeral nature of the nascent social media business means there is really no way to know of Facebook can keep those numbers or if it will go the way of AOL or Myspace.


Despite having given its clients just a week to decide to invest $2m as a minimum investment (word has it that due to demand, the effective minimum was $5 million) and given the dearth of available information about Facebook’s operations and financial condition, Goldman Sachs was reportedly able to close the deal a day early. The overwhelming investor response amounting to several billions of dollars for just a $1.5bn stake sale is a clear sign of investor fascination with Facebook, or a testament to the marketing fortitude of Goldman Sachs. The truth most likely lay somewhere in between.

Given the dearth of financial information under scenario one, we have estimated FB revenues based on subscribers growth and average revenue per user, and have assumed constant profit margin.

To put the amount of optimism used in our analysis in perspective, there are 6,892,839,222 people in the world according to the US Census Bureau’s World Clock. Facebook currently claims 9% of that world population. Take into consideration a material percentage of that population are elderly or very young, infirm, illiterate, poverty stricken or located in remote rural areas and do not have iPhones and Androids, broadband connected computers and Facebook accounts, and may not have these things for some time, if ever. For the extremely optimistic benefit of the doubt, let’s assume that all children down to the age of infancy, the infirm, the illiterate and the Australian outback settlers all are frequent or likely Facebook users. Even with this assumption, Facebook will have to hit 65% of today’s total (as in the ENTIRE) world population (not factoring in population growth/shrinkage) by c.2020 to justify anything approaching a $50B valuation – and that’s assuming they captured 65% of every single man, woman and child in the world along the way - not 65% of those who have access to an internet connected computer.

Thus, it is highly unlikely one can legitimately factor in the type of growth needed to justify the current Goldman $50B valuation - particularly when you consider that Facebook's growth is already slowing!

I make this point in an attempt to illustrate the absurdity of the valuation presented to investors as a once in a lifetime opportunity that you have to make a $2-5 million valuation decision on in a couple of days without audited financials. You may be able to make some money, but the chances are greater that you will trail the average ROR or outright lose a bunch of money than it is you will hit that grand slam. Those Goldman clients would have been better off investing in BoomBustBlog!

Those who wish to subscribe to our research services should click here! You can contact me, Reggie Middleton, here. Professional & Institutional subscribers can download the full Facebook valuation analysis, complete with several valuation scenarios here: File Icon FB note final. And finally, and most ironically - here is the debut of Reggie Middleton's BoomBustBlog Facebook page!

Last modified on Tuesday, 11 January 2011 21:26