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It has often been said that the first phase of the Internet was about putting information online and giving people a way to find it. The second phase of the Web is about connecting people with one another. The Web 2.0 movement is big and impactful, but is there much money in it?
While the valuations of private firms are notoriously difficult to pin down due to a lack of financial disclosure, the often-cited fifteen-billion-dollar valuation from the fall of 2007 Microsoft investment is rich, even when made by such a deep-pocketed firm. Using estimates at the time of the deal, if Facebook were a publicly traded company, it would have a price to earnings ratio of five hundred; Google’s at the time was fifty-three, and the average for the S&P 500 is historically around fifteen.
But it’s not as simple as a raw valuation. The deal was also done in conjunction with an agreement to let Microsoft manage the sale of Facebook’s banner ads worldwide. And Microsoft’s investment was done on the basis of preferred stock, granting the firm benefits beyond common stock, such as preference in terms of asset liquidation.B. Stone, “Facebook Aims to Extends Its Reach across Web,” New York Times, December 1, 2008. Both of these are reasons a firm would be willing to “pay more” to get in on a deal.
Another argument can be made for Microsoft purposely inflating the value of Facebook in order to put it out of reach from most rival bidders. A fat valuation by Microsoft and a deal locking up ad rights makes the firm seem more expensive, less attractive, and out of reach for perhaps all but the richest and most committed suitors. Google may be the only firm with that could possibly launch a credible bid, and Zuckerberg is reported to be genuinely uninterested in being absorbed by the Search Sovereign.F. Vogelstein, “The Great Wall of Facebook,” Wired, July 2009.
Since the fall of 2007, several others have invested private money into Facebook as well, including the Founders Fund and Li Kai Shing, the Hong Kong billionaire behind Hutchison Whampoa. Press reports and court documents suggest that these deals were done at valuations that were lower than what Microsoft accepted. In May 2009 Russian firm Digital Sky paid two hundred million dollars for 1.96 percent of the firm, a ten-billion-dollar valuation (also in preferred stock). That’s a one third haircut off the Microsoft price, albeit without the Redmond-specific strategic benefits of the investment.David Kirkpatrick, “Why Microsoft Isn’t Buying Facebook,” Fortune, May 9, 2008; and S. Ante, “Facebook: Friends with Money,” BusinessWeek, May 9, 2008.
So despite the headlines, even at the time of the Microsoft investment, Facebook was almost certainly not valued at a pure fifteen billion dollars. This isn’t to say definitively that Facebook won’t be worth fifteen billion dollars (or more) someday, but even a valuation at “just” ten billion dollars is a lot to pay for a profitless firm with estimated 2009 revenues of five hundred million dollars. Of course, raising more capital enables Zuckerberg to go on the hunt as well. Facebook investor Peter Theil confirmed the firm had already made an offer to buy Twitter, a firm which at the time had zero dollars in revenues and no discernable business model, for a cool half billion dollars.S. Ante, “Facebook’s Thiel Explains Failed Twitter Takeover,” BusinessWeek, March 1, 2009.
Much remains to be proven for any valuation to hold. Facebook is new. Its models are evolving, and it has quite a bit to prove. Consider efforts to try to leverage friend networks. According to Facebook’s own research, “an average Facebook user with 500 friends actively follows the news on only forty of them, communicates with twenty, and keeps in close touch with about ten. Those with smaller networks follow even fewer.”S. Baker, “Learning and Profiting from Online Friendships,” BusinessWeek, May 21, 2009. That might not be enough critical mass to offer real, differentiable impact. Also, the advantages of leveraging the friend network hinge on increased sharing and trust, a challenge for a firm that has had so many high-profile privacy stumbles. There is promise. Profiling firm RapLeaf found that targeting based on actions within a friend network can increase click-through rates threefold—that’s an advantage advertisers are willing to pay for. But Facebook is still far from proving it can comfortably achieve the promise of these initial efforts.
Steve Rubel wrote the following on his Micro Persuasion blog: “The Internet amber is littered with fossilized communities that once dominated. These former stalwarts include AOL, Angelfire, theGlobe.com, GeoCities, and Tripod.” Network effects and switching cost advantages can be strong, but not necessarily insurmountable if value is seen elsewhere and if an effort becomes more fad than must have. Time will tell if Facebook’s competitive assets and constant innovation are enough to help it avoid the fate of those that have gone before them.