SmoothSpan Blog

Everyone needs to be careful what they wish for, lest they get it.  There’s a buzz in the blogosphere over two deals, one that many think is way too big and one that seems to raise the ire as being way too small.  Ironically, both involve Facebook.  You know things are a bit frothy when you can simultaneously generate many TechMeme hits around the same property, and when the hits are not that interesting.  Although what passes for popular gossip is often uninteresting.

Let’s start with the deal that was too small.  Michael Arrington tells us that Parakey’s investors got a bad deal because they sold the company to Facebook for chump change of “less than $4M”, and they didn’t even get shares, they got cash.  Meanwhile the founders of Parakey got “handsome stock options”.  Apparently the invested got a 2x return after 6 months.  I’ve no doubt the investors were disappointed at the time, but their disappointment at the present is completely irrelevant.

Why?  Play it back without the 20/20 hindsight.  The investors accepted a 2x return after 6 months.  That is well what they need to get to make their numbers.  Check out Will Price’s excellent post to understand why VC’s want 10x multiples.  Worse, they want 10x after a couple of years when it’s 10x on several rounds, not 10x after a few months on very little capital invested.  Now granted there were angels involved, but mighty Sequoia was also involved.  Let me tell you, those guys are smart.  They did not get taken advantage of here, at least not in their minds at the time the deal was struck.

That’s not to say Sequoia was wholly enamored of the deal, only the insiders know for sure whether:

– Sequoia had lost confidence/interest in Parakey.

– Parakey’s founders told their investors they were moving on to Facebook in any event.  The acquisition purely salvaged some value for the investors.

– Investors and Founders became convinced Facebook would crush Parakey if they didn’t give in to being acquired.  Convincing the acquiree of such an eventuality is very typical in tech M&A situations.

As for the founders getting “handsome stock options”, hello?  They got a job.  Jobs in Tech carry stock options.  Yes, those options appear to be worth an incredible fortune now that Microsoft is tickling the value of Facebook, but who knew back then.  The options still have to finish vesting, and Facebook has to generate a liquidity event before they’re worth anything. 

I’ve been involved in a lot of M&A activity in the software world, and deals like this are pretty common.  At Borland, we used to look for companies that had great technology but failed marketing.  The usual formula was to pay the investors similarly to Parakey and give the employees jobs.  Most of the time, everyone was happy about it because great technologies found a real marketing channel where they could finally succeed.

In short, it’s silly to kvetch about the Parakey deal.  This is why Wall Steet says we ought not to look back on stock trades.  We all have a list of those things we should have done.  So what?

The more interesting chess game is Microsoft’s rumored offer to invest in Facebook at an astounding valuation.  Apparently they’d like to acquire a 5% stake and are willing to give up circa $500M for it.  This churns up a lot of questions:  Why would Microsoft want this?  Why would Facebook want it?  Is Facebook worth $10B, let alone the $15B they’re rumored to be asking for as a counter?

Let’s start with Microsoft.  First, they need to find ways to stop the Google freight train from taking over the Internet completely while they get their act together.  Remember, Microsoft historically needs 3 releases for that to happen.  I’ve lost track of which release of their Internet strategy they’re on, but the Internet is not a product, so may require even more releases.  I would count Microsoft’s first Internet release as the browser wars, wherein they thought of the Internet as a product and fought Netscape hard to win the browser wars.  Now they have the leading browser but its entirely unclear how that monetizes.  But we digress. 

Facebook is the hottest available property right now, so making a 5% investment would give them some ability to interfere with Google taking it over while Microsoft figures out what to do.  Remember, they still have $21B of cash in the bank and generate a staggering $17B of cash flow each year.  If you had to deploy the astounding cash flows at Microsoft (and they dont’), $500M represents about a week and a half out of the year.  How many properties are as interesting to spend it on as Facebook when looked at as a week and a half?

GOOG does okay too, but Microsoft will win a cash bidding war.  Yahoo, meanwhile, is completely out of the game on these kinds of numbers.  It’s hard to imagine this had anything to do with slowing Yahoo down.

What’s the Microsoft downside? 

• They can potentially make a return on a $500M investment or not.  They don’t care.  Look at their cash situation again.  Microsoft practically has to bury cash to keep investors from shaking them down to distribute it as bigger dividends.  They are almost too profitable.
• They can end up buying Facebook.  If it looks right, why not?  I bet they wait until some catalyzing even takes place though.  Meanwhile, 5% may give them visibility inside Facebook they wouldn’t otherwise have had.
• They can keep others from buying Facebook.  That’s the nightmare scenario, that a competitor + Facebook can lock Microsoft out of further Internet growth.  $500M is cheap insurance to avoid that.

Okay, we can sort of see how it makes sense to Microsoft.  It boils down to the rich having so much money that prices don’t matter versus aspirations and strategies.

On to Facebook.  Their aspiration is likely to go public.  They want to be the next Google.  This deal is great for that.  They get a bunch of fresh capital to fund further expansion–you can buy a lot of Parakeys to launch into your channel for that!  They get a head start setting a huge valuation on their company for the public markets.  Will Microsoft interfere with their going public?  I would think not.  Seems like its easier for Microsoft to acquire them after they are public, all things depending of course.  It certainly would have been harder for Larry Ellison to buy PeopleSoft had they been private.

This brings us to our next question:  is Facebook really worth $10B?  Very unclear from this transaction.  Microsoft has a vested interest in driving the price up.  Indeed, at one point Oracle told SAP and others they could and would pay crazy prices for acqusitions.   The answer to the real value of Facebook will have little to do with mundane issues, however.  It has to do with predicting the future.  If Facebook continues for long enough on their current meteoric trajectory, they will indeed be worth $10B or even more.  Waiting a little longer to see is another good reason for a company like Microsoft to invest in 5% and not the whole enchilada.  Growth curves can often flatten out when you least expect it.

Fred Wilson says this isn’t about setting a real price at all.  It’s about Facebook selecting a strategic partner and charging them a premium for it.  Fred sees it as similar to moves AOL made.  He’s right.  It is a strategic partnering opportunity, and from that perspective, Microsoft looks a better/safer partner than Google, who wants to build a competing network.  The strategic partner angle is also why Apple makes a bad partner, despite what Scoble thinks.  Yes, they are the l33t style leaders, and they have a vocal community, but it is largely an island.  Such a partnership offers more to Apple than Facebook.

Om Malik gets it with his “put option” concept, but I think he’s wrong to say Microsoft will never sell advertising anywhere else.  Where was the advertising going anyway?  Smaller players will always want to play with grown-up Microsoft.  Most of the bigger players are choosing up sides against each other.  Here Microsoft is at least gaining a dance partner.

Getting back to what you wish for, I’d say all parties are getting what they wished for at the time of the transaction on both deals.  Be careful what you wish for…