4.29.2011

Facebook: A Case Study in the Evolution of the Capital Cycle

Founded in a dorm room no more than 7 years ago, Facebook's valuation already places it among the largest companies in the world. And it isn't even public yet. For those unfamiliar with the machinations of the market, the valuation of private companies and the venture capital cycle, the inherent incongruities between the statements above might not be readily apparent. Suffice to say, it is not typical for valuations of privately-held companies to be so widely known.

For one thing, many privately-held companies are not well-known by the general public. Of course this is not the case with Facebook. But even well-known private companies are typically difficult to properly value. Their numbers are kept close to the vest and investors (often venture capital/private equity funds) often keep very quiet about company prospects. It is only typically in the run-up to an IPO, during road shows, that the market receives an indication of what management and bankers think an entity is worth. 

However, Facebook is not in the midst of a road show right now. Its IPO date is not only to-be-determined, but it is probably not going to arrive until at least next year. So how is it that market commentators are so easily able to quote potential prices for ownership stakes in the company?


One data point is the company's very public mini-fiasco involving Goldman Sachs a few months back. Public relations issues aside, the folks at Goldman are undoubtedly some of the best at what they do. When they purchase a minority stake in a company that implies a certain valuation, markets listen. Facebook has also been a bit more forthcoming with its numbers (at least with potential investors; the rest of us are merely privy to the results of leaks) than others in its position. But possibly most interesting with regards to those who follow the venture capital market is the fact that its shares are already being traded on secondary markets, giving signals through individual block trades of what savvy investors potentially believe the entire company could be worth.

Secondary markets for shares in privately-held companies have really hit their stride the past few years after first coming on the scene about ten years ago. Though under a bit of SEC scrutiny for the potential of the platforms to be used by individuals to skirt public offering laws, they are for now a growing and increasingly viable means for founders and employees to realize value and create liquidity for themselves in advance of, and possibly in lieu of, potential IPOs or acquisitions.

On the other side of trades, they allow investors to put money into companies pre-IPO without the go-between of a venture capital fund. Though smaller companies are not currently traded extensively on these markets, large companies such as Facebook, Groupon and Twitter are already being traded fairly regularly on platforms such as Sharespost and SecondMarket.

These markets for hot pre-IPO shares have not supplanted more traditional forms of final exit for the founders of the Googles, Apples and Microsofts of tomorrow. However, they have bridged a gap that had previously existed in the cycle of a company from formation to funding to exit; they have created a means for shareholders to obtain pre-IPO liquidity and for outsiders to invest in companies that would have been impossible to enter otherwise before 'the big event.'

Thinking ahead (as we are sure the creators of such platforms are doing this very moment) the possibilities are nearly endless. It will be very interesting to see what the next steps in the evolution are. For example will holders of smaller companies find a market for their shares on these platforms eventually? Will an entire company attempt to take itself public on the secondary market? Conversely, will the SEC come in and regulate these companies to ineffectiveness or even extinction?

None of this is clear. However, for now, they are the best way for individuals on 'the inside' to realize the fruits of their labor a bit earlier than their entrepreneurial predecessors were at one time able to. Additionally, secondary markets have allowed (relative) outsiders to get a piece of the action before the IPO and without venture funds as intermediaries. Both of these results are healthy for a well-functioning market intended to both provide capital for those who need it and opportunities for those who have it. Here's hoping that some of the potential problems, regulatory and otherwise, are worked out. If they are, there seems to be almost no limit to how far there platforms could take the venture capital market.

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