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.

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

If this sounds like I’m talking about 2008, CDO syndication of sub-prime debt, and AIG and others offering Credit Default Swaps, or CDSs, as derivates used to hedge against CDO losses¹, you have a good memory, but I’m not.  I’m actually talking about the new European Bailout Fund which was much-hyped towards the end of last week. ²  Maybe the EU finance ministers missed the whole 2008 crisis, but even if they did, it’s hard to believe they expect the rest of us to buy their bonds based on the exact same false premises.  Fool me once, shame on you; fool me twice—oh, never mind.  Here’s the problem:

The Irish government needs a bailout.  They can’t borrow at anything but a junk bond rate.  So the EU announces to much fanfare that the big Trillion Dollar Bailout fund will come to the rescue.  But wait, it’s not a fund.  It’s a “facility,” and it doesn’t currently have a single cent in it. ³   Instead, it’s a facility that will issue bonds itself to other investors.  So the Irish debt has a lousy rating, but magically the bonds the Bailout facility issues turn into AAA securities.  How?  Because the remaining EU member states (those not recipient of bailout funds) put their “full faith and credit” behind the facility and guarantee it.  Heard that one before?  Yes, that’s the phrase everyone thought applied to the US government’s support Fanny and Freddie, but didn’t (and that worked out well, didn’t it?), but it’s also directly analogous to the commitment AIG made in the form of its CDSs before the meltdown.  AIG provided derivatives worth trillions of dollars of CDOs without much regard to whether, if those bundles of CDOs eventually defaulted at higher rates than projected, they would have the capital to post as the collateral required to support those CDS policies. ⁴

Here’s why this European facility looks just like the CDS crisis:  the guaranteeing countries guarantee the debts of the bailed out countries.  But some of those guaranteeing countries (Spain, Portugal, Italy, etc.) are already teetering on the brink.  Which means they may default.  And need bailouts themselves, guaranteed by the remaining countries.  The collateral requirement balloons far bigger than the original Irish crisis:  now it includes failures in Spain and Italy and Portugual as derivate problems of the core crisis.  Just as AIG’s derivatives policies forced AIG to post collateral far greater than the underlying CDOs.  So who ends up holding the bag?  AIG—I mean Germany.  For exactly how long do you think the Germans will guarantee the debts of the mismanaged Mediterranean (and Irish) economies?  This isn’t just counterparty risk, it’s political risk.  The future of the EU itself hangs in the balance.  If the Germans pull out, precisely who would guarantee these debts?

Like any other native New Yorker, the theater-going part of me used to dread the announcement that was occasionally heard just as the house lights went down:  “In this evening’s performance, the role of King Lear, normally played by Sir Anthony Hopkins, will be played by Justin Bieber.”  Everybody in the audience groans.  A few leave.  I’m having that same reaction to today’s performance of the European Bailout Fund.  “In today’s performance, the role of the Guarantor usually played by AIG will be played by Germany.”  We all groan.  You can see the bond fund managers leaving for the doors already.  Oh, look, there goes Alliance Bernstein.  And there goes CALPERS.  I wonder whether PIMCO will stay for the second act….

1. There was also straight out insurance against CDO losses, offered by such firms as FSA;  for more details, read Michael Lewis’s excellent The Big Short: Inside the Doomsday Machine
2. The facility has actually existed since May of this year; last week’s announcement marks the first deployment of the facility.  It becomes a permanent feature of the EU in 2013—if the EU makes it that long!
3. For a some great background information on the European Bailout facility, listen to Friday’s NPR Planet Money podcast.  I can’t recommend Planet Money enough.
4. The problem for AIG was not paying out on these insurance policies, since that was the job of FSA and MBIA.  Instead, it was the hugely inflated requirements of AIG to post collateral as a requirement of the CDS agreements which itself was too much for AIG to handle.

On Thursday of last week, I flew back to San Francisco from New York.  As a regular American Airlines passenger (150,000 miles flown last year alone; 2.5 million accrued one way or another since 1986), I know the airline well and generally have few, if any complaints.  Even when three of my past five flights have been delayed, I don’t find myself complaining.  It’s a hard business.  Everyone loves to hate airlines, and until last week, I had decided to buck the trend and actually like an airline, if only because it seems to me their business is a tough one and I respect their efforts to run it well. When I got to my office on Thursday after my flight, I discovered I had left my iPad on the plane. Such stupidity is, of course, my fault and not the airline’s. It was a 6:45am flight from JFK, which required my waking up around 3:30am to get to JFK, and jammed as I was into a window seat in coach, I slept fitfully throughout much of the flight. When we arrived in San Francisco, I was thus only too eager to get off. Without my iPad.

But thanks to the wonderful “Find My iPhone” function of Apple’s MobileMe, I quickly established that my iPad was (and still is!) in Terminal 3 at SFO (the American and United terminal), and I could even track where in the building it was in real-time. I called American at the airport, figuring this was an easy problem to solve. The iPad was beeping and displaying my telephone number to anyone who found it, thanks to a message I sent it via Find My iPhone.

Nobody at American Airlines stepped up to help me solve the problem. In fact, the people who have refused to take my call, call me back, or otherwise be in touch are the customer service representatives at SFO.  Here are some details of the folly:

• The first person I spoke to, in baggage services, told me that the recovery of lost items was merely a courtesy. She chastised me for losing my item (reminding me, for example, that an announcement is made “twice, sir, to take your personal items with you” when the plane reaches the gate).  She then hung up on me as I asked her what my other options were to get help.  (Note:  California Penal Code §485 disagrees with her interpretation of her duties.¹  Jason Chen from Gizmodo can attest that the law took Apple’s side when he “recovered” a lost iPhone 4 earlier this year, for example, and Gizmodo realized the law required them to return the item to Apple.)

• The next day, I drove back to the airport and talked to everyone I could.  I showed them the location of my iPad using my mobile phone (yes, it’s an iPhone ).  I sent the missing iPad message after message and “beep signal” after “beep signal.”  Everyone was amazed at the cool technology, and indeed, I have since spoken to many people who are very pleasant.  Some even offer to help.  None of them was a customer service representative, and none took the initiative to “own” the problem and solve it.

• Today (Monday), I had to fly out of SFO on American again, so of course I took the opportunity to walk around the terminal and ask everyone I could about my lost iPad.  I showed lots of people the location of the iPad.  I gave my business card to anyone who would talk to me (even a few who thought I was a nutcase).  Still no phone calls—not even from someone saying they haven’t found it yet, but they’re trying.

By now, I have left voice mail messages for American Airlines Customer Service Managers at SFO several times.  No customer service representative (manager or otherwise) has ever called me.

All the while, I have kept in regular contact with my iPad—via Apple’s Find My iPhone.  It hasn’t run out of battery yet, and it hasn’t moved.  It’s still right there at SFO Terminal 3, beeping away whenever I send it a message.  It displays my name and phone number.  All someone needs to do is look at it and call me.

The experience has left me with one primary question:  after all the voicemails I have left and business cards I have handed out, and given direct evidence that the device is in their facility, why has nobody picked up the phone, called me, and taken the opportunity to turn this into a good customer service experience for a very good customer? (Reminder, I fly about 150,000 miles a year with these people.)   After all, I have made it clear to everyone I have spoken to that I am not blaming the airline—quite the contrary, I’m the idiot who left it on the plane.  But we know where this thing is, and after five days of nobody taking responsibility for returning it to me, the burden of responsibility for a bad experience has shifted.  It is not beyond American Airlines to find a device in their own secure area at their own terminal when that device can be tracked by GPS and made to emit a loud noise whenever their customer tells it to.

All they have to do is call their customer.

update 8/11/2010:  Believe it or not, the iPad still has battery, six days later.  It’s still at SFO, still reporting back to me.  Despite this blog piece, and despite tweets with @AAirWaves and calling endlessly, nobody has yet called me, even to explain that they’re still working on it.

1. The pertinent section of California Penal Code §485 reads: “One who finds lost property under circumstances which give him knowledge of or means of inquiry as to the true owner, and who appropriates such property to his own use, or to the use of another person not entitled thereto, without first making reasonable and just efforts to find the owner and to restore the property to him, is guilty of theft.”

source¹

To listen to Robert Nardelli (Chrysler, formerly CEO of Home Depot), his company has minutes remaining.  I’ve certainly expressed a sense of urgency before in my job when working to close a deal, but it’s impossible to listen to him and not sense something profound.  Three of our great industrial giants are willing to speak publicly about endgame.  Rick Wagoner (GM) seriously discussed a “pre-packed” Chapter 7 bankruptcy (surely a trial balloon alternative if ever I’ve heard one) by quoting marketing studies which show consumers are overwhelmingly unwilling to buy a car from a bankrupt company.  When was the last time you heard the CEO of a major non-financial company speaking about such potential downsides alongside his competitors? Extraordinary times indeed.

But not extraordinary enough.

Towards the tail end, Alan Mullaley (Ford, formerly Boeing) was asked whether his company would exceed the new CAFE fuel economy standards.  His response?  That Ford would barely be able to make them, and would not be able to exceed them.  The others agreed with him.  That one response convinced me that any bailout of US automobile manufacturers should 1) be totally focused on saving jobs (millions of them, potentially), and 2) must be so severely punitive of the companies themselves that they don’t get out of jail free.  These three companies have succeeded in lobbying their way out of innovation legislation (fuel economy, safety, public transport, etc.) for decades.  Consumers have responded by choosing foreign manufacturers preferentially (e.g. Toyota who pushed hybrid technology as a differentiator).  US manufacturers drop to the bottom of the list of consumer choices because of the manufacturers’ complacency, and then a contraction comes along and endangers the bottom of the barrel.  Surprise, GM, Ford, Chrysler, you now inhabit the bottom of the barrel precisely because of your complacency!

A little capitalist Darwinism is in order here.  If these guys had worked on fuel economy and alternative technologies 20 years ago, CAFE standards would be unnecessary now.  For want of those prior investments, it is not the Government’s job to subsidize their lack of business skills.  Do what we need to to save the jobs (lest we further endanger the economy), but otherwise I vote let these companies suffer the fate of others who stick their heads in the sand.

1. Businessweek online, “Auto Execs in the Hot Seat” http://www.businessweek.com/bwdaily/dnflash/content/nov2008/db20081118_113319.htm?chan=rss_topStories_ssi_5