James’s Musings

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Facebook Fight: 12 Billion Apples and Oranges

by James G. Beldock on December 31, 2010

Miguel Helft’s ar­ti­cle (“Twins’ Facebook Fight Rages On”) in today’s New York Times re­counts the on­go­ing saga of the law­suit brought by Tyler and Cameron Winklevoss, the iden­ti­cal twin Harvard grad­u­ates who have al­leged that Mark Zuckerberg stole the idea for Facebook from them. Unfortunately, the ar­ti­cle al­so per­pet­u­ates a $12 bil­lion mis­per­cep­tion.

The news in the ar­ti­cle is that the Winklevosses are seek­ing to un­wind their $65 mil­lion 2008 set­tle­ment with Facebook, a por­tion of which was paid in Facebook stock. Their ar­gu­ment is that Facebook’s stock was worth far less than the price they paid for it, and there­fore that the set­tle­ment was con­duct­ed in bad faith and con­sti­tutes an act of se­cu­ri­ties fraud. Unfortunately, Helft’s ar­ti­cle re­peats the same er­ror made else­where:

But ac­cord­ing to court doc­u­ments, the par­ties agreed to set­tle for a sum of $65 mil­lion. The Winklevosses then asked whether they could re­ceive part of it in Facebook shares and agreed to a price of $35.90 for each share, based on an in­vest­ment Microsoft made near­ly five months ear­lier that pegged Facebook’s to­tal val­ue at $15 bil­lion. Under that val­u­a­tion, they re­ceived 1.25 mil­lion shares, putting the stock por­tion of the agree­ment at $45 mil­lion.

Yet days be­fore the set­tle­ment, Facebook’s board signed off on an expert’s val­u­a­tion that put a price of $8.88 on its shares. Facebook did not dis­close that val­u­a­tion, which would have given the shares a worth of $11 mil­lion. The ConnectU founders con­tend that Facebook’s omis­sion was de­cep­tive and amount­ed to se­cu­ri­ties fraud. 1

To any­one who has run a pri­vate com­pa­ny with ven­ture or pri­vate eq­ui­ty in­vestors, this state­ment sim­ply doesn’t smell right. What is missing—but crit­i­cal­ly important—is men­tion of what type of shares were be­ing val­ued in each trans­ac­tion.

In a typ­i­cal ven­ture cap­i­tal-backed com­pa­ny, there are two class­es of stock: Common and Preferred, with very dif­fer­ent rights and priv­i­leges. Common stock, typ­i­cal­ly held by founders and of which op­tions to pur­chase are grant­ed to fu­ture em­ploy­ees, and Preferred stock, of­ten in sev­er­al se­ries each with spe­cial terms, rights, and con­di­tions (such as the right to earn a div­i­dend on their in­vest­ment, to get their mon­ey out first ahead of the com­mon stock in the event of a liq­uid­i­ty event, the right to ap­point board mem­bers, and many, many oth­ers, in­clud­ing the right to con­vert each share of pre­ferred stock to some num­ber of shares of com­mon stock in the event of liq­uid­i­ty). Throughout the world, both pub­lic and pri­vate com­pa­nies have dif­fer­ent prices for com­mon stock and pre­ferred stock. (Remember Warren Buffet’s $5 bil­lion in­vest­ment in Goldman Sachs at the height of the 2008 cri­sis? He bought con­vert­ible pre­ferred stock at a com­plete­ly dif­fer­ent price than the com­mon stock, in re­turn for a 10% div­i­dend yield, war­rants on ad­di­tion­al com­mon stock, and oth­er rights he ne­go­ti­at­ed for.) Here, for ex­am­ple, are two Citigroup se­cu­ri­ties, the ven­er­a­ble C, and a pre­ferred vari­ant, Preferred Series I, over the past six months (click the thumb­nail to ex­plore on Google Finance):




Two Different Citibank Securities:Two Different Prices!



More of­ten than not, the price of Preferred shares in a ven­ture-backed pri­vate com­pa­ny is de­ter­mined by fi­nanc­ing events (e.g., when Microsoft in­vest­ed $240 mil­lion in Facebook in October, 2007). But pric­ing events for Common shares are far less, er­rr, com­mon. Unless some­one ex­plic­it­ly pur­chas­es Common (a fair­ly un­com­mon event :-), there sim­ply aren’t pric­ing events for those shares. Instead, ven­ture-backed com­pa­nies gen­er­al­ly hire an out­side val­u­a­tion firm to come in an provide a val­u­a­tion for the com­mon shares given the ex­is­tence of all of the oth­er pre­ferred shares. This is im­por­tant, be­cause pri­vate com­pa­ny Common is near­ly al­ways last in line for liq­uid­i­ty, of­ten be­hind lit­er­al­ly hun­dreds of mil­lions of dol­lars of pre­ferred liq­ui­da­tion pref­er­ence. Naturally, such Commons there­fore car­ry a low­er price. It is this low­er price that the out­side val­u­a­tion ex­pert pro­vides. To those in the in­dus­try such a price is called a 409(a) Valuation, af­ter the 2004 IRS code sec­tion which re­quires such a val­u­a­tion to be per­formed in or­der for stock op­tions grant­ed at that Common price not to trig­ger de­ferred com­pen­sa­tion tax li­a­bil­i­ty. In 2007, IRS is­sued its fi­nal rul­ing on 409(a), and the 409(a) Valuation process be­came an an­nu­al rit­u­al for all com­pa­nies which is­sued stock or op­tions on stock for which a mar­ket price was not read­i­ly avail­able.

Which brings us to the Winklevoss’s fight with Facebook. They al­lege that the 409(a) Valuation per­formed in ear­ly 2008 set a price they should have been of­fered in their set­tle­ment. As a nar­row point, whether this claim is valid or not de­pends on whether they re­ceived Preferred or Common shares as their set­tle­ment pay­ment. There are few de­tails re­gard, but some sources say they re­ceived Common Stock—at the Preferred price. Such a cal­cu­la­tion would give the Winklevosses and their at­tor­neys at least some leg to stand on in their ar­gu­ment. (The redact­ed tran­script of the hear­ing is on­line here, and it makes clear that coun­sel for the Winklevosses in­ten­tion­al­ly ig­nore the dif­fer­ence be­tween Preferred and Common stock val­u­a­tions.)

But what their claim does not mean is what oth­er news sources have in­ferred: that the en­tire val­ue of Facebook was equal to the 409(a) Valuation for the Common Stock times the to­tal num­ber of shares of Common and Preferred out­stand­ing (= $3.7 bil­lion). Why? Because do­ing that math com­plete­ly ig­nores the val­ue of the Preferred stock and its rights. By this same log­ic, Warren Buffet’s in­vest­ment in Goldman should have been at the same price as the com­mon stock was trad­ing at that day. (It wasn’t.) And every ven­ture Capitalist who spends days ne­go­ti­at­ing pref­er­ence rights in a fi­nanc­ing is ne­go­ti­a­tion for some­thing worth $0. (It isn’t.) In re­turn for pay­ing high­er prices for Preferred shares, in­vestors get board seats, vot­ing priv­i­leges (of­ten on be­half of the Common), div­i­dends, and, at least in a star­tup, of­ten com­plete con­trol over the company’s bal­ance sheet and stock ledger.

Three things are clear from the court pa­pers:

  1. Facebook Preferred stock car­ried a price of $35.90 in late 2007 when Microsoft in­vest­ed its $240 mil­lion;
  2. Facebook’s Board ap­proved a 409(a) val­u­a­tion of $8.88/share for its Common Stock in ear­ly 2008;
  3. If the Winklevosses re­ceived a num­ber of shares of Common Stock equal to a set­tle­ment val­ue ($45 mil­lion) di­vid­ed by the Preferred price, they have some­thing to ar­gue about, but that ac­tion it­self does not mean that the Preferred and Common had the same val­ue.

The val­ue of Facebook thus did not fall be­tween the­se two events, as has been var­i­ous­ly and mis­tak­en­ly re­port­ed. Those two prices sim­ply re­flect the val­ue of ap­ples and or­anges. The Times mis­takes the mat­ter when it re­ports that “expert’s val­u­a­tion . . . put a price of $8.88 on its shares,” ei­ther in­ten­tion­al­ly or un­in­ten­tion­al­ly agree­ing with the Winklevoss’s at­tor­neys who tried to con­fuse the mat­ter. That val­u­a­tion put a price of $8.88 on its Common shares, not its Preferred shares. And while the dis­tinc­tion may be a tech­ni­cal one, an en­tire in­dus­try of ven­ture cap­i­tal­ists, pri­vate eq­ui­ty, and pub­lic in­vestors re­lies on it every day. Reporting oth­er­wise doesn’t help the pub­lic un­der­stand the mer­its (or lack there­of) of the Winklevoss’s al­le­ga­tions.

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  1. M. Helft, “Twins’ Facebook Fight Rages On,” Page B1, New York Times, December 31, 2010. Emphasis added. []

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