Facebook’s quasi-IPO raises regulatory & valuation concerns

By Dan Hallett, CFA, CFP on January 4th, 2011

The financial media are abuzz about Goldman Sachs’ $450 million common share investment in Facebook for a tiny piece of the popular company.  As I read a few reports of this latest round of financing, it occurred to me that Goldman bought more than a pile of common shares, that this deal could spur new regulations and Facebook’s implied valuations gave me a bout of déjà vu.

What did Goldman really acquire?

News reports like the one linked above note that Goldman paid $450 million in cash at a price that values the social media powerhouse at $50 billion (all dollars in USD).  This implies a 0.9% stake in Facebook.  To put the size of the deal in perspective, consider that Goldman generated more than $9 billion in net income over the most recent four quarters –  twenty times the size of its investment.  But Goldman secured a few side-benefits as part of its investment deal.

First, Goldman probably stands to benefit substantially when Facebook floats its formal IPO.  While typical IPOs fetch underwriting fees of 5% or so of the offering size, it’s likely that Facebook could probably negotiate that in half.  At a 2.5% fee, an IPO of $9 billion would give Goldman fees to cover half of its recent investment.  Post-IPO stock sales to smaller retail clients would trigger lots of trading commissions plus any gains realized from selling from its ‘house account’.

Second, Goldman effectively acquired options or rights to acquire up to an additional $1.5 billion in equity at the $50 billion company valuation.

Third, it struck a deal to acquire these additional shares through a so-called special purpose entity (SPE).  The SPE is being set up to allow Goldman to offer its private clients a way to invest in Facebook shares with the SPE counting as a single investor – regardless of how many of its clients buy units in the SPE.  While few details were provided, I expect Goldman to charge a fee to “manage” the SPE.

Finally, Goldman is likely to leverage the caché of being able to offer clients exposure to Facebook shares for good PR and to persuade private clients to bring more business to the firm.

Will regulators clamp down on secondary private market?

Through the various reports on this latest deal, there was mention of trading in shares of Facebook.  The name that continues to surface is a U.S. broker-dealer called SecondMarket.com, which facilitates trading in various “alternative investments” by connecting accredited investors, professional investors and the like.  But Facebook remains a private company, so I was surprised to learn that such a robust market could exist for private companies without complying with the regulatory requirements of publicly-traded entities.

Goldman’s planned SPE could raise another interesting issue.  It’s one thing for a broker-dealer to organize private placement trades for accredited investors and professionals but it’s quite another for Goldman to effectively offer Facebook shares to hundreds of wealthy clients through this soon-to-be-created SPE.  I wonder what sort of disclosure will be available to Goldman’s private clients given that Facebook remains a private company and is not required to release detailed financial data.

I wouldn’t be surprised to see regulators step in with some views of their own (and perhaps some disclosure rules) since this is really just an IPO in disguise.

Is Facebook valuation a throwback?

One of my concerns around investments in this SPE centres on investor behaviour.  All too often, investors are wooed by a company’s ‘story’, often at the expense of even basic financial due diligence and valuation.  In fact, my conversations with many retail investors over the years has led me to believe that most investors buying stocks don’t know how to value a business.  And I fear that investments in Facebook, via Goldman’s SPE, could end badly.

Failing more details of Goldman’s SPE, the deal appears to lock in a company value of $50 billion.  I found a few sources quoting Facebook’s 2010 revenue at $2 billion (a figure likely to have originated from Facebook).  Assuming that’s true, this latest round of financing implies a price-to-sales ratio of 25 times.  This level of valuation brings back memories of figures I thought I’d never see again.

In the summer of 2000 JDS Uniphase announced a deal to acquire SDL Inc.  I remember being struck by the $41 billion deal at the time because it valued SDL at 50 times revenue (and 371 times earnings).  While Goldman’s investment in Facebook is rather frothy on the surface and brings back memories from a decade ago, this is a bit different.

In 2000, most deals were simply exchanges of overpriced pieces of paper.  For instance, the JDS-SDL deal was inked in July 2000 at a value of $41 billion.  Just five months later, the deal value was cut in half thanks to JDS’ sinking share price.  Goldman’s investment is all cash and Facebook is a younger business on what appears to be a very sharp growth trajectory.  (From various reports, it appears that Facebook’s 2010 revenue growth was in the 300% range but this can’t be verified since no audited information is available.)

Still, 25 times revenue is a very steep price.  And paying with cash is a more expensive proposition than paying with overpriced shares.  The memory of the ridiculous JDS-SDL deal should at least remind investors that many glamourous stories have gone down as costly mistakes.