The media has been on fire the past few days about Goldman Sach’s investment on Facebook. In case you’ve been living under a rock, they raised $500 million, which values the company at $50 billion.
A few side notes first: I’m by no means an expert. My undergraduate degree was in Finance, but I have very little practical experience valuing startups, which is an entirely different beast than a well established corporation that has decades of historical data to work with. Much of this is based on a discussion I had with a former professor of mine, Frank Anderson. He’s a great level headed guy who worked in the industry for many years before leaving to teach.
Corporate Valuation is a function of cash flow over time. Essentially, Goldman Sachs modeled what the expected future revenues to be and discounted them back to a present value using a rate of return they determine. Then they invested about 1% of that total valuation ($500 million). This is extremely over simplified, but it’s the general idea. 37Signals tackled it in a much funnier blog post.
I’m skeptical. Goldman Sachs is an outstanding investment bank. Whether or not their practices are ethical, they’ve managed to weather the storm in the financial industry over the past few years, mainly by betting against mortgages. However, Goldman always has an alterior motive.
In this case, it’s been widely reported reported that the investment bank would (to put it simply) create a giant investment vehicle for their high wealth clients to “buy” a slice of Facebook. Minimum buy? A sweet $2 million. It’s nothing new for them. From a private Bloomberg article:
Principal investing — in which Goldman Sachs uses its own money, instead of clients’ money, to buy stakes in companies or real estate — generated a total of $9.4 billion for the firm since the end of 2001, company filings show. The business can be volatile. In 2007 the unit contributed $3.8 billion in revenue and the next year it lost $3.9 billion, company filings show.
Additionally, they make insane fees off managing these clients, and don’t underestimate the importance of an old wealthy guy bragging on the golf course that he invested in Facebook. You’d be surprised how bad wealthy people are at actually managing their money.
There’s also the preferential status that Goldman Sachs will receive to manage Facebook’s IPO. That will usually net them 4% of the total IPO value, maybe closer to 3% with FB, since it’ll be so high.
From the New York Times:
Goldman’s critics have long complained that the firm puts its own interests ahead of clients. In the Facebook deal, Goldman is investing $450 million, at an implied $50 billion valuation. However, Goldman clients are paying a 4 percent placement fee and a 0.5 percent expense reserve fee for their shares, as well as giving up 5 percent of gains. That means Facebook would need to be worth closer to $60 billion before they make any money.
Beside those fees, Goldman is likely to earn additional money from ancillary business — with the biggest victory coming from an eventual initial public offering, perhaps as soon as 2012.
I purposely waited to write this article until some of Facebook’s numbers leaked. A $50 billion valuation is completely arbitrary without knowing the company’s current financials. Luckily, it didn’t even take 24 hours, as reported by the Wall Street Journal:
According to people familiar with the document, Facebook had net income of $200 million in 2009 on revenue of $777 million. Figures for 2010 weren’t disclosed, but analysts have said the company’s revenue last year could be as much as $2 billion, fueled by advertising growth.
Even if we go with the aggressive 10x growth in 1 year for $2 billion, that would imply that Facebook is valued at 25 times over their revenue. Just for comparison’s sake, Google is trading around 8x ($194B market cap vs $23B in revenue) and Apple is trading around 5x. That’s ok though, theoretically Facebook is a less mature business – but 25x is pushing it.
It’s pushing it to the point that another Goldman unit, Goldman Sachs Capital Partners who manages pensions and sovereign wealth funds, passed on the opportunity to invest:
But the unit’s head, Richard A. Friedman, a longtime Goldman partner, decided the Facebook deal was not suitable for his clients, in part owing to the high valuation and to a mismatch with his investment criteria. The $450 million investment values the Web company at $50 billion. After Goldman’s deal, some industry experts cautioned that Facebook’s growth would need to accelerate rapidly over the next couple of years to justify such a steep price — a risk with many brand-name technology upstarts.
The key to the deal is that the Wealth Management group isn’t actually giving investment advice, they are simply facilitating an offer that these high net-worth clients can buy a stake in Facebook directly.
To me, this feels like the dot-com bubble burst. Venture Capital has been flying out to the most absurd investments over the past year or so, and it’s got to get out of hand. In the end, value in companies doesn’t come from private investors saying they think it’s worth that much, but pure cash flow and profit. The fact that a free web browser can raise $9 million (unscientifically it’s probably not worth more than the talent at the company) just goes to show how inflated all startup valuations are right now.
My professor probably put it best: You don’t see Warren Buffett investing in any of these companies, do you? When he does, I will take a closer look.