Management: Facebook's backdoor IPO

USD500 million is a lot of money for a small company, especially one which has a business model that has more in common with the companies at the heart of the tech-stock bubble than it does with companies that have a tangible product and an infrastructure.

US memories are short: it's less than a decade since the technology sector found itself in the death-grip of harsh realities. What went wrong was simple, although many seek to complicate it.

Companies have an underlying value which is based on the value of their assets in a fire sale; regardless of the best efforts of the accounting and marketing industries, the value of brand is not quantifiable in this simple way. Therefore investors in brands not product face the danger of a spectacular collapse.

At the forefront of the collapse in the early 2000s, were telecoms companies. Their collapse arose due to three primary factors:

first, they bought or developed cutting edge technology which, as soon as it was installed, had a real (not book) value of approx 10% of its cost;

secondly, their investment bankers, financial advisers and accountants sold the idea that a company had value simply because it had sales. One US company was valued in one round of share issues at 17 times its annual "revenue," i.e. amounts billed, regardless of whether those bills were paid - and without regard to profit.

Third, telecoms companies suffered from a combination of churning (sales agents migrating customers from company to company to maximise introductory commissions) and a major lack of customer loyalty: for some corporate customers, inertia was an issue but for smaller businesses, less so: and when telecoms resellers created the "least-cost-routing" model, providers were drawn inexorably downwards in their pricing models. And pre-aid customers displayed little or no loyalty to their resellers choosing whatever was the cheapest call rate on the day they bought their card, again, leading to a catastrophic collapse in the price of services - and due to to the failure of downstream resellers, the upstream providers saw debt increase and the prospect of profits (and therefore the means to pay debt) evaporate. The only way to survive was to return to the markets repeatedly.

In addition to the collapse in telecoms companies, across the aisle, e-publishers had also been pumped on a similarly false basis: the supposed value of those companies came not from profits nor, even, the crazy notion of "revenue" but from something much more akin to the highly mobile customers of pre-paid telecoms services: "eyeballs" i.e. the number of visitors, regardless of spend.

Facebook has, except for a number of dubious trademarks and its name, remarkably little of any true value. In that it is the same as most "Web 2.0" companies. The simple truth is this: if the company died tomorrow, some of its software might have value, the data it has collected (and famously refuses to delete) has value in the increasingly dubious world of data-interchange between companies and it has a stack of hardware which, history shows us, will sell for about 10% of its purchase cost.

But Facebook is not, on the face of it, part of a stock bubble because it is a privately held company.

Although that is now open to question.

The investment by Goldman Sachs (USD450 million) and Russian investment house Digital Sky Technology (USD50 million) announced during the New Year break creates a notional valuation ofUSD50,000 million for the company that is - one has to remember - only about five years old and has yet to make a profit. Some of the most profitable parts of Facebook are not owned by Facebook at all, but by private games designers who use Facebook as a platform.

But even though Facebook is a private company, the valuation placed on it will no doubt have a halo effect on (some) other Web 2.0 companies. Others, such as Friendster, MySpace - arguably already sidelined by the growth of Facebook - may see their own value suffer in relative terms due to perception of value in the market leader rather than genuine commercial value. It was reported late last year that NewsCorp had decided to redesign, relaunch and then sell MySpace which does not have the media presence of Facebook but still attracts a goodly number of visitors especially in its new positioning as a launch platform for the arts. Indeed, some argue that MySpace's laser-like focus attracts higher quality (and therefore probably spending) visitors than Facebook's scattergun approach).

Aside from the dangers of signalling another bubble, the Goldman deal raises an equally important but very different issue: is the structure of the deal a way to a back-door IPO and to the avoidance of regulatory supervision of one of the USA's largest (by notional market cap) companies?

The blunt answer is that the deal is, on the face of it, entirely within the rules. It is also entirely outside the spirit of those rules.

For what Goldman Sachs has planned, it has emerged and is widely reported, is that the shares will be held in a so-called special purpose vehicle and shares in the SPV will be offered to targeted investors.

There's a complex set of inter-dependencies for US corporate reporting insofar as private companies are concerned: any company with more than USD10 million in assets must provide specified financial information to the Securities and Investments Commission. But the rule applies only to those companies with 500 shareholders or more. An SPV, vis-a-vis the company it holds shares in, is a single shareholder. Therefore a company can have hundreds of SPV shareholders, each with less than 500 shareholders who are, indirectly, investors in the company.

So what's in it for Goldman Sachs? The answer is simple: it can sell investments in the SPV to its qualified investors (who must meet certain criteria as to net worth, trading history and others). In short, the SPV will be, to all intents and purposes, what the USA has generally mis-termed a "hedge fund," that is a private investment fund with a specific and narrow purpose. It will be able to charge what it likes for membership, to specify the returns it will provide and to charge a management fee.

Facebook is far from being the first company to use this device to keep the number of shareholders on its share register as unrepresentative of the number of people who are in fact exposed to it. And it is not making an IPO with such a device, despite its expanded ownership.

It also allows those sophisticated investors to take an early stake in the company so that, if and when it does head for a full floatation, they will be in pole position. But this is not an "angel" or venture capital style investment where the company needs the money for development and growth. Facebook's accounts are not fully public. Either it needs the money to keep going or it is preparing to make someone very rich indeed.

And the scheme appears to be designed to avoid allegations that Facebook is offering shares to the public and to ensure that it keeps its financial affairs under wraps for as long as possible.

In the meantime, the deal's headlines scream about the supposed value of the company.

That's exactly what happened every time Enron or Worldcom raised more money, dragging sentiment and gambling along behind the fictional values placed on those companies.

And that's why it is important that information about Facebook - which holds and trades its visitors information and refuses to delete it even in the face of express requests and yet keeps its own position remarkably quiet - must be made available, regardless of whether the deal is within the letter of the rules.

For if there's going to be another bubble, then screaming a supposed value of USD50,000 million for a website, however, many visitors it has (a significant number of which use only free-to-use but costly-to-provide) services will create what amounts to a false market in other Web2.0 websites, most of which have - like Facebook - a very limited model to produce profits.

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Nigel Morris-Cotterill is Head, The Anti Money Laundering Network, ultimate owner of ChiefOfficers.Net. When a lawyer in London, he was involved in dealing with a number of frauds in the telecoms industry including those relating to investment fraud in the USA.