Actual Value vs. Potential Value and the Facebook IPO

The biggest thing Facebook had going for it, going into its IPO, was the perception that it not only has a wealth of data that similar companies lack, it has the potential to transform that data into a phenomenal money-making machine. Its current performance does not justify a $100 billion + valuation, or even half of that amount. The hope was that enough investors would gamble on its potential to produce and sustain a valuation that is not supported by the numbers or by any known business plan held by the company.

If you wanted a sign that Facebook has no plan to generate the earnings necessary to support its proposed (or present) stock market valuation, you need look no further than its acquisition of Instagram. It makes sense for a company, seeing a threat on the horizon, to act quickly and proactively. But the amount paid, the promise to Instagram users to maintain it as a separate service, and the fact that Facebook was not able to mitigate the threat of Instagram by any means other than acquiring it, all serve to highlight its vulnerability. Not in terms of its mass of users, the extension of its platform and login system into third sites, and other such actions that do reflect commendable foresight and capability by the company's leadership. If you believed before that acquisition that Facebook's position is so dominant that it cannot be upset by a start-up, or that Facebook has clear focus on a single platform and won't end up fragmenting its platform and distributing its focus and resources on multiple properties, that acquisition should have made you reconsider.

And that's without mentioning the most obvious reason to believe Facebook lacks a plan to generate the revenues that would justify its valuation: The fact that no such plan has been implemented. I don't want to sell Facebook short (no pun intended) but I can't think of a better time for Facebook to have demonstrated its capacity to generate massive profits than over the past year. Instead it appears to be demonstrating that each additional user it acquires actually costs it money. To draw that conclusion on the available data would be premature, but it's not an impression I personally would have wanted to leave room for, going into an IPO. It reminds me of the comments I heard from an analyst, talking up Facebook's future, by suggesting that the company has enormous capacity to expand in China and India. Well, I'm sure it does, but how is that going to generate profits?

Reuters reports,

Facebook Inc's underwhelming debut on Wall Street increases the pressure on the social networking giant to deliver stellar growth - a novel situation for Chief Executive Mark Zuckerberg, who has been clear he is more interested in building products than making money.

If the lead-up to the IPO didn't pressure Facebook to deliver stellar growth, why would the present situation? Facebook is "only" worth $76.3 billion? Its key shareholders will "only" be able to spend their profits over sixteen to twenty lifetimes instead of thirty or so? Go ahead - put me under that kind of pressure. I dare you.

The second part of that statement, to me, is an echo of the hype we've been hearing ever since Facebook was worth fifteen... no, thirty... no, fifty... no, one hundred billion dollars. Zuckerberg is saying "Gamble on me, gamble on the future of this company, gamble on the idea that with phenomenal amounts of money available we'll build some jaw-dropping products." If you're buying Facebook stock with something else in mind, you simply haven't been paying attention. In a sense it's fair for the article to point out that Facebook is a profitable company and that many other multi-billion dollar companies of the current Internet bubble are gushing red ink, but that's simply a reflection of the hubris of the bubble. Facebook is "worth" $76 billion or so because of that profit - if it were gushing red ink, it might only be "worth" $40 or $50 billion to the same set of investors.

Can we at least be this honest? When, going into an IPO, a company expresses "that 'we don't build services to make money; we make money to build better services' and refer[s] to the company's 'social mission'", that company may well make the coolest stuff in the world but it has little to nothing in the pipeline that it expects to generate revenues that would justify its proposed valuation? I'm prepared to be surprised, even shocked, by an announcement that upsets my expectation and proves the genius of the speculators. But....

The Biggest Threat to Facebook: Data Liberation

Facebook's strengths and weaknesses are summarized reasonably well on CNET, with the leading strengths being reach (the huge number of Facebook users), dwell (the huge number of hours a typical U.S. user spends on Facebook) and lock-in (you can't get the same social experience elsewhere). When I speak to people who use Facebook they emphasize that last point: they use Facebook not because they particularly like it, but because that's where their friends, kids, grandchildren, grandparents, and distant relatives... pretty much everybody in their lives, can be located. And when they comment on why they don't have Google Plus accounts, or why they don't use their Google Plus accounts, it boils down to "I don't want to check multiple sites and a lot of my friends and relatives are only on Facebook."

Google understood that and, in launching Google Plus, made obvious the benefit of porting their Facebook information over to your Google Plus account. Facebook panicked and slammed the door shut, twice. Work-arounds appear to remain, but they involve more work than the typical user is going to do. History suggests that if Facebook sees a significant uptick in the number of users exploiting a work-around, it will shut off that avenue as well.

Meanwhile, Google has taken to talking about how its users own their own data, and has coined the term "data liberation". They have a dedicated engineering team focused on mak[ing] it easier for users to move their data in and out of Google products.

Users should be able to control the data they store in any of Google's products. Our team's goal is to make it easier to move data in and out.

At present, at least from a U.S. standpoint, pretty words, right? What are the odds that Congress is going to get in the way of Facebook's claiming to own your data. But then there's the E.U.

Key changes in the reform include:...

• People will have easier access to their own data and be able to transfer personal data from one service provider to another more easily (right to data portability). This will improve competition among services.

• A ‘right to be forgotten’ will help people better manage data protection risks online: people will be able to delete their data if there are no legitimate grounds for retaining it.

Google is, in a very real sense, using its present position of strength to its advantage. People are tied into Google for a range of functions that Facebook does not offer, and are unlikely to switch over even to one of Google's more direct rivals. But if they create an environment in which the users of other services (who, for the most part, already have Google accounts) can more easily break Facebook's lock and replicate their experience on Google Plus, over time Facebook's advantage will erode.

Facebook's cautious IPO suggests that they know their present weakness, and that investors understand it as well. There is no indication that Facebook needs the money it's going to raise through the IPO, unless "need" includes the desire of certain early investors to cash in. Facebook has managed to grow, support itself, acquire other companies, and sign up pretty much every easily attainable Internet user in the world without going public. Their $5 billion offer is "real money", but the odds seem pretty good that those shares will be snapped up by investors hoping that Facebook will become the next Apple or Google, investors who can afford to take the risk that they'll be more like MySpace or even pets.com. A larger offering would run the risk of quickly saturating that market, then establishing a void of demand for Facebook at its exceptionally high claimed valuation. There's a point at which investors start to weigh performance against potential, and the more weight you put on performance the less shiny Facebook looks.

I think it was pretty brilliant of Facebook to try to shift from being a social network to a platform, as evidenced by the fact that Zynga accounts for a huge percentage of its revenues - and an even larger portion, when you consider Facebook's profits from ads on Zynga pages. But for the platform aspect of Facebook, its present revenues would look pretty weak. But as people increasingly use portable devices, a platform in their own right, are they going to want to go through Facebook to access Zynga, or are they going to want to access Zynga games the way they access Angry Birds - through a standalone app? Zynga can as easily pay Apple a 30% commission on sales of virtual tractors (I'm sure Apple appreciates Facebook's setting that commission point), and can do even better through the Android platform - and Zynga's shareholders, no doubt, want to see it grow well beyond the walls of Facebook. Facebook's apps have been criticized as under-featured, but how do you create an app for use on a rival platform? If the app is good enough that people don't use your web interface, you're "just an app". And if you try to become a platform on a platform - "Load the Facebook app, then load additional apps through Facebook" - you're going to have difficulty replicating the experience of using a native app on the device in your user's hands.

Facebook has also done surprisingly well with advertising revenue, selling billions of dollars worth of ads to be viewed by people who aren't in consumer mode. But unless they can translate that into something along the lines of AdSense, such that their ads are placed on third party sites where people are in consumer mode, they seem to have a growth problem. Outside of China, pretty much everybody who is likely to be an active Facebook user is on Facebook, and Facebook is reluctant to try to enter China. Adding more nominal users doesn't generate revenue (or sell virtual tractors). How do you increase revenue per user without making your ads a huge money loser for advertisers?

What's the future of Facebook? Beyond noting that it's going to be around for many years to come - that if it fades it will face in the manner of MySpace or Yahoo, not in the manner of Pets.com - nobody knows. That's both a strength (as seen by its ability to hype up its valuation based on potential and the theory (echoing the first Internet bubble) that they'll find a way to generate huge revenues from their user base. If you have the money to gamble, and are in the investor class that is only looking for one in three of your investments to show significant returns, why not buy in? But if Facebook cannot hang onto the elements that lock people into its services, its being the only social service with your great aunt Marge and Farmville, the lock-in effect starts to fade. And with changes to its interface and privacy policy seemingly driven by a desire for profit, whatever its impact on the user experience, Facebook's drive to prove its exaggerated value could turn out to be what triggers its decline.

Investing in the Misunderstood

Fred Wilson has some words of advice for people looking for places to invest their money:

When people ask me, "how do you know which companies and services are going to be the biggest successes?", I usually tell them to look for the companies and services that are mocked and misunderstood. For some reason, that correlates highly with the biggest breakout successes.

That seems reasonable, to a point. If you see momentum toward a product or technology that "doesn't make sense to me", odds are you're missing something. And the more investors who say, "That doesn't make sense, so I'm not going to invest in it," the more opportunity there is for those who see its virtues, or don't see its virtues but trust in the wisdom of the crowd, to become early investors in a technology that may turn out to be the next big thing.

As a VC, Wilson has experience investing money in ventures that fail. So I don't want to read too much into his defense of Twitter, a phenomenal social success that has had great difficulty translating traffic into revenue.

For years, every post, column, or article written about Twitter would have comment after comment making fun of a service where people "told the world what they had for lunch." Of course, people were doing that on Twitter and people still do that on Twitter. But what those mocking Twitter were missing is that in between the tweets about pizza and pita were posts about politics and poetry. There was substance in the midst of nonsense.

I've commented on what I believe to be the primary attraction of Twitter, the illusion of close contact or relationships with other Twitter members, including celebrities. But whatever you make of Twitter, and even if you filter the wheat from the chaff so as to read about "politics and poetry" rather than "pizza and pita", it's difficult to see how that distinguishes Twitter from other technologies or starts it down the path toward profitability. Before the public's attention shifted to Twitter feeds and walls, the blogosphere was ridiculed for its superficiality - despite being full of good political commentary, poetry, and information of substance that in a Twitter feed would appear only as a link. Twitter is not a unique, stand-alone phenomenon, but is part of a progression of technologies that facilitate the public exchange of information. But is that enough to make it viable in the longer-term? It's an open question. The dot-com graveyard is full of good ideas that attracted traffic but made no money, as well as companies who did not find a way to monetize their ideas before they were copied and commoditized by others, and even of companies that briefly made money before being supplaced by something "newer and shinier" or swallowed by and incorporated into a larger company.

If I were investing millions in startups, and expected that only one in three of my investments would succeed, a company like Twitter might look like a good bet. Get in early enough and there's a possibility of making serious money when the company finds a way to turn its traffic into cash. Even if the company never figures out how to turn a profit, it may still be possible for it to go public and provide a huge return on my investment at that time. But as an individual, investing on a very different scale and with very different expectations, my first real chance to get in on a company like Twitter is after the IPO - and if you look at recent IPO's for similar companies, if you join the early rush to buy their stock on the promise or expectation that they'll eventually figure out a path to profitability you're apt to lose some money.

The Lifespan of Dot Coms

A while back I read an editorial that argued,

It appears to take about 10 to 15 years for technology to improve enough to make a new idea powerful enough to dislodge the incumbent money maker on the Web. To date, no one has been successful at turning around an Internet company that is past its peak.

I agree with that in part - it has proved to be very difficult to turn around a failing Internet company. But I disagree with the author's concept of the 10-15 year lifespan, or her reasoning behind asserting such a lifespan.

Consumer-oriented Internet companies are brought to life through the application of a new technology and then unseated about 10 years later by a newer technology. Yahoo had an incumbent advertising platform (display ads) that couldn't do advertising as well as Google search. Google today has an incumbent platform that can't do better than Facebook because Facebook began with a clean sheet of paper and an extra 10 years of technology.

But take a look at MySpace, "unable to turn itself around despite its first-mover advantage", and ask yourself whether that had more to do with outdated technology, or its acquisition by a company that didn't know what to do with it. For an example from much earlier in the life of the Internet, Yahoo! and Excite ran neck-in-neck until Excite was acquired by @Home Networks, and its subsequent tanking seemed to have a lot more to do with post-acquisition management decisions than with technology. I similarly find no merit in the notion that Facebook has an a technological advantage over Google - I suspect the opposite, particularly in relation to its core service of social networking - or that it's nascent advertising platform is going to be Google's undoing.

But as I see another dot com bubble emerge, with our being urged to believe that perennial money-losers like Angie's List, companies with no clear path to significant earnings like LinkedIn, or companies like Groupon and Facebook that respectively claim that their brand is so powerful that we can ignore their unprofitability or that their valuation is justified by their potential to develop new revenue streams from a large user base, I can't help but be reminded of the first dot com bubble.

First, the thing that makes Internet companies so attractive to investors or buyers (and here I'm speaking of VC's, angels and corporate acquisitions, not ordinary investors) seems to be the same thing that makes them vulnerable to collapse. You can start a dot com with a good idea, a tiny core staff, and a seven figure investment. You can create a company ostensibly worth billions that has (or rents) a server farm, and has a few hundred to a couple of thousand employees. But if what the company does is not special, or does not remain special, a competitor will have the opportunity to take most of its market share. When a genuine competitor is available, minor missteps by management can have serious consequences for the company's long-term viability.

Although it's an imperfect test, one interesting thing about companies like LinkedIn, Groupon, Facebook, Twitter and the like is how little disruption there would be if they dropped off the face of the planet. If you woke up tomorrow morning and you weren't an employee of Zynga, how much would your life change if you found that Facebook was gone? Minutes? Hours? If it would take you days, odds are you're either a major online marketer or you simply aren't invested enough in Facebook to take the time to set up, say, a Google Plus account.

Second, no company can survive in the long-term unless it has a path to profitability. If you want to roll the dice on the IPO of an unprofitable or barely profitable Internet company and you're not an insider, recent IPO's confirm that you should wait for the dust to settle as the share price is likely to drop significantly within days to weeks. Even then, you're evoking the expectations of the first dot com bubble - that "eyeballs" will translate to massive profits before the company burns through its cash and investor confidence wanes.

If an Internet company brings nothing special to the table, and barriers to entry remain low, and they lack either the vision or the capital to preempt a "new kid in town," it's reasonable to expect that they will eventually be replaced by a "cool new" alternative. And once your popularity tanks, no matter how cool you were the first time around, if you want to pull off a comeback you will probably need to rebrand.

Google Cash or Facebook "Stock"

What a bidding war:

Executives at both Facebook Inc. and Google Inc., among other companies, have held low-level talks with those at Twitter Inc. in recent months to explore the prospect of an acquisition of the messaging service, according to people familiar with the matter. The talks have so far gone nowhere, these people say.

But what's remarkable is the money that people familiar with the matter say frames the discussions with at least some potential suitors: an estimated valuation in the neighborhood of $8 billion to $10 billion.

I would take the cash.

Seriously, I understand why Google is willing to overpay for a company to gain a strong brand and advantage in the marketplace, particularly given its own faltering efforts to enter social networking, and I understand why Facebook would want to keep a significant potential competitor out of Google's hands, but until the Facebook IPO occurs its stock value is every bit as speculative as Twitter's - and it's very complicated to sell, even assuming that the terms of the sale don't require Twitter's investors to sit on the stock until after an IPO. So I would be grateful to Facebook for forcing Google into a bidding war, would sell to Google and, as they say, "Take the money and run."

Despite the high valuations, Twitter's executives and board are continuing to work on building a large, independent company. People familiar with the situation said the company believes it can grow into a $100 billion company.

Because you would expect them to be saying, "We hope we find a sucker to buy this place for vastly more than it's worth before it goes belly up?" Hey, guys, I think my company can grow into a $100 billion company as well. I'll let it go for a mere... let's say $5 billion. A bargain.