Facebook « discourse and notes

There is a conflict in theoretical finance between technology evolution (obsolescence) on one hand, and the concept of perpetuity (ongoing concern) on the other. In theory, business appraisal is based on a series of cash flows capped off by a terminal value, reflecting an enterprise profile extended into an indeterminate horizon. In reality, the modern enterprise does not lend itself to such easy extension. What, for example, was the forecasted terminal value of the telephone company twenty-five years ago, and what can it be for the wireless carrier today? How confident did we feel then, and how confident do we feel now in pinning down an exit multiple, or in determining the cash flow profile on which to base it? How can we know the line of work of, say, a broadcaster in five years’ time? When we take in Amazon and WalMart in the same picture, which one do we see as most likely to compete with Facebook, and exactly how? And how likely is it that Facebook’s evolving platform will displace Google’s, or Groupon’s, or both, or neither?

It is a question of relativity, I suppose. IBM the typewriter company may in its day have been as difficult to appraise as our contemporaries, but the foreseeable future then was (at least according to nostalgia) more robust than it has become. In the long term, then and now, everyone is… you know… but the long term is now the least of our problems. When two-year old companies are transforming retail and retail is transforming entertainment and entertainment is driven by social media, which is driven by perpetual innovation, our financial models fall apart beyond Year One. From a valuation perspective, the rapid-fire transformations imply that equity value, more than ever, is really option value. We invest in order to be in the game, so to speak, and in our assessments the best we can often do is try to avoid clear mistakes, focus on certain themes, try not to miscalculate the markets, and follow guideposts with some degree of flexibility.

In media, which encompasses a great deal today, one set of guideposts that we can navigate by – there are several – are the following three value drivers and pillars of competitive differentiation: technology, profit, network effect; not necessarily all three, and not necessarily in that order. As we look at the sector holistically, as we try to the best of our ability to sift through the distractions, unpredictability, and option value disguised as equity, these three areas of strength may be as close to a permanent rule as we will likely encounter. In this context, if the following leaders are now seeming to emerge from the crowd and set themselves (permanently?) apart – Amazon, Apple, Facebook, Google (and Microsoft?) – the event is more than happenstance. In regard to technological advancement, profit generation, and network effect, these companies have proven their superiority and are prime exhibits to demonstrate the theory posited. We can probably proceed from this basic core and analyze new opportunities according to its rules. Whether a new or mature business, the parameters of judgment seem to have been established.

Invention, which is to say, innovation, is dealt with in entrepreneurial circles all the time. It’s dealt with so much, it borders on singularity. It has gotten to the point, in fact, where innovation and entrepreneurship have become synonymous, at least in some of these circles. This is understandable, because enterprise must always introduce new things – even if these are merely improvements of older ones – in order to grow, or, to begin with, get noticed. Less understandable, however, is the relative scarcity of discourse around a subject that is as important to entrepreneurs as that of invention: the context in which invention occurs, which is to say, the human experience. One could argue, just to be argumentative, that in the past several years the most successful new ventures in digital media and related technologies have been quite light on innovation. One could argue, just to raise the point, that these companies have, on the contrary, excelled in a most untechnical field: the humanities.

For example, there is Zynga, whose consumer-facing platform is, on the surface, uniquely un-innovative; the company almost takes pride in this. That Facebook launched and thrived at a time when MySpace and Friendster had already introduced the social networking idea and its general framework is well known. For the hundreds of millions of Twitter users, that platform’s technical weakness has become a feature (i.e. the Fail Whale). Yet these companies became enormously valuable because they hit home where it most matters, and where hitting home is the most difficult to do: with people and their fickle ways.

An even clearer illustration of the point may be the contrast between Apple and Google, both technologically ultra-superior but approaching the market from diametrically opposite directions. Apple, on one hand, uses its technical prowess in a highly controlled, highly designed, almost artistic style of product creation, with emphasis on popular appeal through esthetic form. Google, on the other hand, is a rapid-fire new-product launching pad, brimming with features and dazzling functionality. Apple has turned media, telecommunications, and entertainment on their respective heads through a handful of sector-defining innovations. Of Google’s dozens of product launches, we still mainly use it for search (and email). Almost all of the popular others, such as YouTube, Earth, Analytics, were acquisitions, and Android is a platform rather than a product per se. Google famously emphasizes engineering above all else, while Apple’s CEO prizes his study of calligraphy and has, in addition to Apple (more than once), also created a movie company called Pixar. The relative stock charts of the two competitors illustrate their respective trajectories.

To be clear, the argument is not in favor of the arts (or the humanities) at the expense of technology, but in favor of the combination and against either one alone. The argument can, in a certain sense, be distilled to Groupon Now versus the myriad ad placement and filtering platforms that presently populate the world of web media. The Internet ad networks, exchanges, and other intricate targeting mechanisms are built on highly complex algorithms that seek to improve the efficiency of contextual placement through demographics, time sensitivity, page location, click-through functionality, and a variety of other nuances designed to extract the additional fractional penny from a low-margin advertising product. This is pure technology. Groupon Now, undoubtedly complex behind the user interface, is built on two consumer-centric options – “I’m hungry” and “I’m bored” – which, come to think, summarize the human condition absolutely. Groupon has grown to $1 billion in net revenues in less than two years, although it has invented little.

What Groupon, Apple, Facebook, and others mentioned or unmentioned in this article seem to grasp, is that human nature can’t be understood by algorithm. And even if it could be – although it can’t – but even if it could, the builder of the program would first have to understand human nature.

The most important scene in The Social Network – the movie that, in any order, is about Facebook, its founder, and entrepreneurship – takes place around its beginning. I am thinking about the sequence in which Jesse Eisenberg, that is to say, Mark Zuckerberg, in the course of a late night develops a program for students to rank the female population at Harvard University on the basis of comparisons between portraits posted online. Routinely this anecdote has been interpreted as emblematic of the protagonist’s low ways, which interpretation misses the mark entirely. The most important takeaway, rather, is this: The Harvard servers crashed that very night.

In other words, the product developed on a whim by young Zuckerberg, that is to say, Eisenberg, was so perfectly suited for the market into which it was offered that its popularity overwhelmed the system. In the referenced sequence we are led to understand that the founder of Facebook is not only a brilliant programmer, but brilliantly astute in the nature of his audience. He gave the people so exactly what they wanted, and packaged it for them so exactly the way they wanted it packaged, that the poor Harvard server farm, designed as it had been for late-night study and a steady drip of email traffic, was unable to handle the onslaught of humanity – as it were.

That Facebook has been an overwhelming popular success, (created by the same Jesse Eisenberg after all), is no wonder. There had been other social networks at the time when Facebook found its way onto the scene, so it isn’t as though the concept was any kind of breakthrough. The packaging, however, was. Because what young [Jesse] understood better than his competitors, at least in the movie, was the value of exclusivity… And what a wonderful irony it is that a network founded on the basis of exclusive connections now boasts, in real life, more than 600 million subscribers. In all seriousness, Mark Zuckerberg truly understands his audience. Anyone can write code.

(It is a similar experience to witness, from a detached and nearly academic perspective, the way in which the market behaves at times after a lukewarm batch of economic news. It’s all in the packaging also! And here too there is a kind of genius at work, with a subtle understanding of the customer. For example, when weekly employment data is issued in line with or better than expectations, only to be revised for the worse the following week – by which time the market has moved on, trading on that following week’s release, and can no longer be bothered with adjustments – this is brilliant. If this were a movie, the audience would cheer. One analyst has watched the pattern closely and has pointed it out, which is neither here nor there… It is like pointing out to 600 million Facebook subscribers who love exclusivity that there is something inconsistent about the number and the concept.Â The expression, I believe, is: “to fall on deaf ears.”)

In any case, the idea of something falling on deaf ears is a desirable idea when one would like one’s message to stand out while others are ignored. When one is building a business, or trying to sell a product, this is often so. In order to advance the cause, to progress towards that point at which your customers turn away from other products or other messages, you must give the people exactly what they want. Repeat: what they want, not what you do. Nobody, not even at Harvard, wants to study late. It takes a powerful desire to crash servers and rally markets.

When we say “bubble” these days in relation to tech and venture investing, we really mean “herd.” There are important distinctions. The frenzy that occurs in a bubble and causes values to spike without fundamental underpinning is an almost indiscriminate frenzy. When a herd moves, on the other hand, even when this is irrational and lacking in fundamental support, it is in a singular, purposeful direction. The difference is not one of degree as much as scope.

The dot-com bubble of the late ’90s was aptly named, as it was then only necessary to slap a dot-com suffix onto a business name – regardless of its nature – to get immediate attention from investors (and sometimes much more than that). The real estate bubble was aptly named because it swept across all markets and categories. The broader markets today may well be in a bubble, as asset prices have almost indiscriminately surged across categoriesÂ since the implementation of QE2, which may or may not soon come to an end. If and when it does, we’ll find out for sure.

In contrast to these examples, the phenomenon leading to a 50% increase in Facebook’s trading price in a period of months, or leading us to talk about a $25 billion post-IPO valuation for Groupon, is the same phenomenon that would lead an investor syndicate to fund a pure startup with $41 million on the basis of an idea that seems trendy enough and a team that has some experience. While these data-points may resound bubbly, these are in fact outliers in the broader sense. The $41 million injected into Color is the equivalent of at least twenty interesting new businesses that are not being funded. The money finding its way into Facebook in secondary private markets is money not flowing elsewhere in the same general category.

Unlike a bubble – which suggests an investor mentality driven by exuberance and swagger – the examples cited above strike me much more as emblematic of fear: fear of missing out, fear of taking chances where the terrain is untested, and, by corollary, safety in numbers. As introduced all the way at the top, this is quite literally the behavior of a herd.

I don’t want to rush to call the Color situation genius, but the beauty of it is that it both reflects the environment described and feeds on it. Why $41 million? Why not 40 or 4 or 42 or 400? Unlike any of those other figures, $41 million implies incredible precision and thoughtfulness, and at the same time a substantial sum that is not going too far into plain excess. That would have been $50 million… after all, we’re talking about a start-up… and we can almost hear the secondary market gears grinding already, as angels and VCs will no doubt want a piece of that action. We can already see the imitators crowding around with all sorts of â€œaugmented reality” angles for the money that’s been left out.

Unlike a true bubble, again, this pattern is presently still one of narrow focus, regardless of the whims and fancies that may change from one month to the next; and there is a very different reality down below. Out on the street, as it were, and despite the abundance of seed investment vehicles that have popped up (herd-like in many ways) during the past year or two, very smart entrepreneurs with very good ideas and prototypes still have a difficult road ahead. Raising start-up capital is still a grind for most, and may be a grind even for those who are successfully seeded as they proceed to bigger rounds in a shrinking venture capital segment.

In short, here also, in the scrappy domain of entrepreneurship, innovation, and (what should be) meritocracy, the world is not exactly the way it should ideally be. Unlike in a true bubble scenario, in which there are almost only “haves” anywhere one looks, in the scenario depicted – one driven by herd action – there is a large and perhaps growing divide between “haves” and “have-nots.” A true bubble would in some ways be fairer.

Back in the day when broadcast media was radio and television, it would have been interesting, although at the time unthinkable, to see a station perfectly mirror another – without compensation – and build a successful business on the basis of differentiated features: Say, more entertaining ads, or voiceovers with commentary, or free hardware units to secure proprietary traffic. It would have been even more interesting to see the broadcaster encourage that sort of behavior – gratis – in order to boost distribution of its content through diverse channels. Such notions were unthinkable at the time for a variety of reasons that for the most part can be filtered down to this: closed systems.

The closed system of traditional broadcast was manifest in ways that impacted revenues, expenses, capital investments, financing risks and their mitigating factors – all these and others often interrelated. For example, there was the proprietary nature of spectrum allocation, which was a unique asset with value derived from spectrum quality and signal strength and market size and such issues that made media something like a real estate business, in which advertisers were like tenants paying rent, subject to the quality of the premises and location. As there are multiple buildings and options in given territories causing property owners to compete on features and price, so too broadcasters competed on proprietary content and otherwise syndicated this out for a fee. The closed system was in this environment both a defining technical quality and a way to protect one’s investment. Giving the asset away at no charge would have been, as previously stated, unthinkable.

That was a while ago, and the broadcast mechanism is different now. The closed system described has been opened up by the Internet, in which – net neutrality confusions notwithstanding – the quality of signal and its ubiquity have been equalized for all. The original broadcasters have adjusted to this revolutionary change in incremental steps such as Internet radio and Hulu – both of which are still works in progress – while the new media entrepreneurs have gone straight to the outer limit without caution. What used to be unthinkable for broadcast at its origin has become thinkable indeed, and we are watching a fascinating development to illustrate this very point in the rise to prominence of UberMedia.

With Twitter as the original broadcast mechanism, UberMedia has accumulated a portfolio of the top Twitter apps – mobile and otherwise – that leverage Twitter’s broadcast content (in a manner of speaking) to improve on Twitter’s user experience. For this, Twitter derives no compensation, directly or indirectly, despite having made UberMedia possible. What’s worse, the critical mass of users that UberMedia has accumulated – users that are arguably more loyal to the UberMedia app than to Twitter as the underlying platform – is almost as though UberMedia has conducted a hijacking of Twitter’s traffic, and in so doing is transforming Twitter from content broadcaster to “dumb pipe.”

The issues to which the Twitter and UberMedia dynamic gives rise are so multiple that one wouldn’t know where to begin. The dumb pipe question already posed, for example, in turn gives rise to questions not far removed from net neutrality itself, especially if Twitter should see fit to close its openness and set limits on its API, or even – gasp – start charging for it. Barring such actions, there is the question of Twitter’s valuation and, more specifically, its defensibility. There is as well the list of ramifications outside of Twitter, for other open platforms that may be similarly subject to audience manipulation. And at the heart of these and many other issues, of which we are now only starting to catch a glimpse, is this:

As the Internet matures and as platforms are forced to become actual businesses, the ideology of openness will have to be reconciled with economics. Unless one owns the Internet – as Google and Facebook are aiming to do – such a reconciliation could prove highly problematic in half-measures.

Whether there is a bubble or not – an argument now taking place with greater frequency in both Internet and more general capital market circles – is a misplaced debate. There is, in actuality, both a bubble and not, depending on criterion, depending on many things, most of all depending on perspective. The answer is so much more nuanced than commonly assumed, it’s even possible for a bubble and not-bubble to coexist in the same data-point. First, my definition:

In capital markets a bubble exists when perceived value exceeds (by far) the fundamental economic basis of an asset. Although seemingly straightforward, this definition is itself a breeding ground for circularity and debate. Are economic fundamentals not also a matter of perception, and is perceived value not more a question of the future (which nobody really knows) than the present? Because of such murkiness, it is an accepted truth that we don’t know a bubble until it’s popped. So, if a bubble does not pop, is it less of a bubble? What if it does not pop next year but some time in the next decade? (Maybe the answer is that a bubble will eventually pop.) Does it matter when? And when it does, what if it pops for reasons unrelated to present circumstance or presently established fundamentals?

These mind-twisting questions aren’t so much academic as illustrative of the subject’s complexity. When Facebook, for example, is valued at $50-$70 billion on a given private-trading day, the 25-35x revenue multiple is both bubbly and not, depending on whether Facebook’s potential takes shape next year, the year after, or never. It also depends on how that future potential is defined, and by whom. And if Facebook never lives up to expectations, this does not make such expectations irrational but only lacking prescience, which won’t be known for some time. By the same token, if Facebook is indeed worth 35-times revenues, it does not mean that Twitter should necessarily be, let alone Foursquare, let alone Quora. On the other hand, any of these could be worth even more.

To further complicate these discussions, the supply-side of money flows has recently been pumped and manufactured. The subject of quantitative easing in its successive iterations, and the impact thereof on money supply and asset inflation, has been debated as much as – and is in fact part of – the bubble discussion. The case has been made that the market is now divorced of economic fundamentals and is more correctly reflective of liquidity that continues to be infused. So, maybe Facebook, Twitter, Quora, and the S&P 500 index all correlate to money supply more closely than to prospects. But does such liquidity then not itself become economically fundamental? At what point does liquidity even become the focal point, and is that necessarily a flaw in the system or just a repositioning of variables?

When looking back on the last couple of years and the sweeping global shakeup that these have brought to bear – in market mechanics, in fund flows, in economies, in technology, in behavior, in circumstance, and in relations among such characteristics and others – one starts to realize that we are presently more limited than ever in our ability to come to a definitive view on the components of value and economic fundamentals. Trying to do so often feels like trying to grab hold of particles in a volatile solution. For this reason, perhaps, if there is any kind of bubble building it is manifest in a flight to quality, size, and popularity, because therein lies solid ground. In short, the flight is to consensus and consolidation.

In Facebook there is some safety in knowing that 600 million users agree, in the voluminous high-yield market there is paper that can be more easily traded than a micro-cap business-loan, in precious metals there is the perception of a lasting symbol in limited supply, in the Fortune 500 there are global platforms on which one can confidently stand, and finally, in a seed or venture capital syndicate that includes highly-credentialed investors, there is perceived risk-mitigation in the opinion of others. Does all that comprise a bubble? Not really, and at the same time, without doubt.

To make a point, we will consider the case that follows on the basis of generalities and absolutes. This won’t be a pure mirror of reality, because in reality there are differences in nuance, shade, overlapping definitions, and all manner of other murkiness that keeps most arguments from ever truly transcending theory. Nevertheless, there is sometimes a bit of truth in theory, and we rely on it when reality is difficult to pin down due to its complexities.

First point: It is increasingly possible to segment the new media landscape into three categories – information, entertainment, and social, (leaving aside for purposes of the present discussion the more recent manifestations of transactional, the subject of a previous article here). Second point: It has also become accepted that Apple, Google and Facebook are now the dominant forces in the industry. Third point: It follows, I believe, that we should be able to assign each of these three a leadership position to correspond with one of the three sub-segments, in such a way as to preserve their individual dominance without overlap and establish a boundary around their leadership domains.

For the sake of simplicity, we can start with the most obvious designation: Facebook is the lead in social media, and this statement requires no belaboring. The next case is perhaps less straight-forward, because there is more overlap between the subject competitors in the entertainment segment. We give the lead, however, to Apple on account of its iTunes and App Store prowess, the iPod/iPhone/iPad trio that deliver the entertainment possibilities of iTunes and the App Store in a way still unmatched by any other platform, and Apple TV, which, among its peers in web-television hardware-software combinations, is the front-runner of the pack.

This leaves Google with information media, the remaining chair in the game. But it is more than process of elimination that brings us to this point, because Google – synonymous with “search” – really is about information. This is a notion that should be as obvious, on reflection, as Facebook’s synonymity with social media. If such a conclusion is not always automatic and maybe even at times debatable, that’s because Google has made efforts in the last few years to expand out of its natural zone and define itself broadly. It has tried to compete with Facebook in social, it has tried to compete with Apple in entertainment (and other things), and it has tried to enter a variety of new fields even. Despite all these attempts and their mixture of results, Google remains the lead in information, almost without trying.

Now, while Google has been restlessly seeking to branch out every which way, its co-leads in industry domination have for the most part stuck to their core. Apple did put forth a half-baked attempt to enter social media, but Ping is really an adjunct feature of iTunes – an entertainment product. And, yes, Facebook has talked about search, but really as a social media tool and most notably in partnership with Microsoft. All the while, both Apple and Facebook have worked diligently to perfect their respective cores and foremost to explore new angles and new areas within these.

Can the same be said of Google? Has Google made an honest effort to explore all the possibilities of information media – a field that extends far beyond search – and has it sought to redefine what information media means… that is, in a similar way that Apple and Facebook have done in their fields of entertainment media and social media?Â These questions are asked rhetorically, because on the surface the answer seems to be in the negative. Now with new leadership, or with the same leadership in a new format, perhaps there is an opportunity for Google’s approach to change. Maybe a focused segment vision, as described, can unlock enormous potential and tap into untapped value yet.

The idea of specialization in networks has been manifesting itself with growing regularity and in multiple locations. Just the other day a columnist on TechCrunch questioned whether a service like Quora can be truly for the masses, or whether it is fated to remain of special status as a club of garrulous techies and other web aficionados essentially conversing with each other. Perhaps this is going too far, but the idea is anyway not about insularity as much as it is about niche. It is about a unique value proposition in a vast web community with multiple facets.

The subject occurred in a different manifestation on the A VC blog a few weeks ago, in a post about the existence of multiple social graphs. Among other subjects of that article was the inclination of those within the social web to use different networks, different services, for different reasons. LinkedIn, for example, professionally; Twitter to collect information; Facebook to connect with friends online; Foursquare to connect with friends in person. There, once again, the principle was implicitly challenged, that one network (even Facebook) can adequately cover all of our social bases; and the notion of necessary niches was thus again put forth.

In both of these instances – arguing the case for network specialization – one comes away wondering why the reality of networks, (agreeing as I do with the respective authors), is that way. Why do we gravitate to one social interaction for one purpose and to another for another? Functionality plays a big role, no doubt: For example, Twitter is a clunky picture sharing service while Facebook is much more effective. But this is not always an accurate segmentation of circumstance, and oftentimes characteristics overlap: Tweets and updates are not very different, and if one really wished it one could create a personal LinkedIn profile to exceed professional limitations. By the same token, discussion topics are found on LinkedIn in ways not dissimilar to questions on Quora; and people can be followed on Quora just as they can be on other networks.

I realize that there are differences of nuance in each of the examples cited, but I question to what extent such differences are the cause or the effect of our custom. Why don’t we use LinkedIn updates interchangeably with tweets? Well, in fact, many do, and truth be told, it’s annoying. I have no problem scrolling past endless drivel on Twitter, but I shouldn’t have to do so on LinkedIn. It is a personal quirk, maybe, but maybe it also speaks to how we become conditioned, and how our expectations are established.

With such reflections I begin to think that there is more arbitrariness to the way social networks emerge than we realize, and that the rigid functionalities of our social networks are formed at the very origin of these. We use Facebook the way we do because we always have; we use Twitter the way we always will; we ask certain questions on Quora rather than LinkedIn because it is expected. These are all habits that have been formed, and that will not be altered. Any new use, any new social graph, will thus require a new network.

It has been a week of large and unexpected change in digital technology. The week began with Apple’s announcement about the departure of Steve Jobs and his temporary replacement by Chief Operating Officer Tim Cook, and it is ending with Google’s announcement about the departure of Eric Schmidt from his Chief Executive Officer position, to be replaced by Larry Page, who will be focused on execution. A COO emphasis at Apple, and execution focus at Google. Such perfect bookends for a week to kick off earnings season.

These themes taken together serve to remind us that the sector is entering a season of maturation. In one way or another, we talk about maturity and mature issues when we talk about operations, execution, big changes at high levels, and for that matter very sizable cash balances that continue to accumulate. To be clear, maturity in the context of this article does not imply diminished growth, but a diminished rate of acceleration, at least in contrast with the 10-15 years past. Attention to detail and competitive positioning, in this context, takes on paramount importance, and a COO background for the CEO may be the ideal calling card. (The subjects of innovation and execution were covered in a previous article here already.)

And when we talk about such mature issues involving Google and Apple, we really should not leave out Facebook from the discussion. Because just as Google may be challenged to find a substantial growth area outside of its core search business, and as Apple may not be able to continue its 10-year roll of disruption much longer (iPod, iPhone, iPad, etc.), so too Facebook is at some point going to test a few limits. For example, December data shows that Facebook’s U.S. growth has probably plateaued, with the U.S. contributing only 5% of new users during the month. Applications supported by Facebook are arguably only beginning to crystalize, but revenue growth will always be closely linked to user growth, and the subscriber statistic referenced is not insignificant.

All of the above notwithstanding, it’s too soon, undoubtedly, to throw around maturity labels – especially in any financial sense – in a discussion about Apple, Google and Facebook. Nevertheless, it may not be too soon to speculate and to think about next steps for these three sector giants. Projecting out a few years… what? And what, especially, given market valuations predicated on growth for a long time to come, (in the case of Facebook most of all)? In mature industries – say, like digital technology and consumer media in a few years, when Zuckerberg’s like 30 – participants begin to consider consolidation possibilities or other strategic combinations. (In the media industry more recently, the cable segment consolidated, and then Comcast bought NBC.) Projecting out a few years… what will Google, Apple and Facebook muster up?

Oh, I don’t know, but it is great fun to speculate, and as I play around with permutations and combinations among the subject trio of this article, my conclusions seem always to point to one likely outcome: Apple and Facebook. I usually begin my speculations with the idea that Facebook’s vulnerability will always be the sources of its revenue, which will always create an internal conflict with Facebook’s source of popularity – private user information. Were Facebook not under pressure to make money, this conflict would not exist. By extension, Facebook can only reach its full product potential when advertising revenue is eliminated from its business picture.

A combination with Google will not resolve this issue, but will in fact aggravate it, and for this reason (among others) any strategic combination between Google and Facebook is likely to face some regulatory obstacles. Apple, on the other hand, does not sell advertising. Apple, moreover, quite possibly never will. Apple sells product as a hardware vendor, and Apple sells software as an app retailer. In neither of these cases is the use of private data of any consequence or advantage. What Apple does not have, however, is a network with a network effect, and this adds pressure to the company to keep creating new products that are better than last year’s, every year.

Now, we’re talking about a maturation scenario, remember, in which Apple at some point in the future may no longer be able to keep this up. And we’re talking about Facebook in a scenario in which subscriber and advertising growth are in a natural state of tension. Would it not make sense, at such a point, for Facebook and Apple to combine in a unified business model that does not require advertising or use of private data, and that is based off a unified content distribution platform? Considering the emphasis on operations, execution, and sundry subjects of maturity for all parties involved, maybe this point arrives sooner than one would expect. And anyway, why wait?

Among the reasons offered by some for the collapse of Google’s acquisition of Groupon was the seller’s discomfort with regulatory approval-risk. This immediately leads me to think about Facebook. There is only a handful of suitors that would both want and afford to buy Facebook, and I can’t imagine which among these combinations would coast through the regulatory process unscathed. If Groupon should face challenges, certainly Facebook will. Now, granted, Google as a buyer could be the riskiest deal of all, but any other would only be marginally better. Consider the enormous influence that any such combination would represent, given Facebook’s 500 million personal contacts and sets of private data.

Which all leads me to consider Facebook’s exit alternatives more broadly, as its venture investors will at some point require a liquidity event. Much of the guesswork around this subject has been directed at the “if and when” of a Facebook IPO. That’s fair enough. In contrast with any other industry titan worthy of the label – and according to many observers Apple, Google and Facebook will one day divide the world between them – the latter is the only private company. It is a disadvantage that cannot continue unchecked, but the issue is valuation. According to the most recent secondary trading activity, Facebook minority interests are being valued in the private market at the equivalent of $40 billion for the company. According to published reports, Facebook is expected to generate some $2 billion in revenues this year. In order for the most recent investors to break even – without even any gain – an IPO priced today would have to be valued at 20 times revenues.

This is, of course, egregious, even in a market smitten by Facebook’s cachÃ©. Including a control premium, Groupon was only offered some 3-10 times revenues, depending on which article citing unnamed sources one chooses to believe. On an operating income basis, if Facebook’s current revenue base generates, say, $500 million, the company would have to be valued at some 80 times operating earnings, which is even for a growth company rich. Apple is only trading at a P/E multiple of about 20, and that’s using a smaller denominator of after-tax, after-interest, after-depreciation income. In other words, if Facebook has been publicly downplaying the near-term possibility of an IPO, maybe this is because it still needs time to grow into the valuation attributed to it by private investors.

Until it does so, however, and assuming that Facebook’s cash flow is in the general proximity described, there is perfectly good liquidity in the coffers of banks, hedge funds, and a variety of lenders who should be only too happy to advance $1 billion – a mere 2 times operating income – which billion dollars could be distributed as a dividend to shareholders. Details and logistics aside, forgetting about structural issues and preferential differences between classes of stock, in keeping with the back of the envelope and off the cuff tone of this article, a special dividend of $1 billion would return all of the capital invested into Facebook since its founding, with an additional 20% or so to spare. And every investor could continue to ride Facebook’s potential undiminished because not a single share would be redeemed. Maybe once the loan is paid back in three years, and if an IPO has still not at that point happened, Facebook could do it all again, but this time for even bigger numbers.

Despite the particular nature of this article, there is a more universal point, which is this: Having been born in a world dominated by venture capital and IPO considerations, it is easy for web businesses (of which Facebook is a prominent example) to forget that their sector is at least as close to media as it is to technology. While technology is difficult to leverage, media is not. The financial considerations described herein are in no way innovative, and are in fact antique. Prior generations of media companies have understood that, in addition to M&A or an IPO, there is another investor liquidity solution called a leveraged recap. They used to do this all the time. Maybe the kids now can also.

discourse and notes

Tag Archives: Facebook

Technology, profits, network effect, not necessarily in that order

Innovation is not only technical

Know your market well and overwhelm it

A bubble would almost be fairer

Can’t reconcile openness and business fundamentals in half-measures

A bubble according to last year’s definition

Time for Google to embrace its role and thrive

The origins of networks and their specialties

Apple, Facebook, as they age

Now that Facebook is a media titan, a leveraged recap would suit it well