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):
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:
- Facebook Preferred stock carried a price of $35.90 in late 2007 when Microsoft invested its $240 million;
- Facebook’s Board approved a 409(a) valuation of $8.88/share for its Common Stock in early 2008;
- 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.
- M. Helft, “Twins’ Facebook Fight Rages On,” Page B1, New York Times, December 31, 2010. Emphasis added. [↩]