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  • Investing in Facebook Now? Buyer Beware: Is buying Facebook private stock a scam? 0 comments
    Dec 30, 2010 11:38 AM

    For those of you who do not know me well or are not familiar with my background, in a previous life I was a Financial Advisor/Investment Banker. I have extensive experience in investing in private companies for myself and with/for other Angel Investors. Currently, I am Founder and CEO of linkedFA.com. linkedFA is a social network designed to provide Financial Professionals the ability to leverage the phenomenon of social media while remaining compliant with industry regulations. linkedFA is a privately held company funded by myself and a small group of Angel Investors.

    I made a decision to write about this topic because I have been approached no less than ten times in the last three weeks from industry professionals, my personal broker and friend, as well as other Angels from my group all requesting that I blindly jump on the band wagon and buy Facebook stock. This was also a main topic of discussion over cocktails at the National Investment Banking Association (OTCQB:NIBA) conference a few weeks ago. I find myself asking if the world has gone mad. Here I am communicating with groups of sophisticated Angel Investors and veteran Investment Bankers and all they could talk about is how to get their hands on Facebook stock.

    No one seems to be asking the important questions. How is this possible? What is the valuation of the company? If Facebook intends on taking the company public soon, why would an investor give up their shares now? Why would the shares be available to individual investors and not go to hedge funds and institutions? It seems to me that these questions do not have satisfactory answers, and in my opinion, someone is selling hype! As a disclaimer, I have not had the opportunity to review any prospectus or specific documentation, but as the old adage goes, “If it sounds too good to be true, it probably is.”

    To fully understand this we need to understand how a transaction like this works. Keep in mind that I am not privy to any of the original financing documents for Facebook and I am speaking in general terms based on a typical transaction of this nature. Several years ago Facebook would have done one or more Angel rounds of financing and then subsequent Venture Capital financings (which we all know occurred). Those investments would be documented by some type of legal agreements such as a Term Sheet or Private Placement Memorandum (PPM). Over the years we have all seen the valuation of Facebook rise to an unprecedented amount. The valuation increase has been based on more and more financings that continually increase the value of the company and has been based primarily on the company’s user growth.

    A company will generally go public (through an Initial Public Offering or IPO) for one of two reasons: 1) to raise capital; and/or 2) to provide an exit strategy for early-stage investors. In either case the purpose of going public is to attract the highest valuation possible. This is typically done by breaking up the shares into smaller units and selling them to less sophisticated retail investors who have longer investment horizons. An IPO is a great way to bring in more capital and increase the value of the company as more people buy stock, however if the company is seen as overvalued, an IPO will result in a diminished valuation of the company as the stock drops. The question is how to determine the value of Facebook, and I believe the answer resides in the actions Facebook has undertaken, as well as the questions they still face. It would be in Facebook’s best interests to do an IPO if they were undervalued and are able to sustain a rapid growth rate because the IPO would most likely attract a much higher valuation. Why have they held off? Have they somehow found a way to translate their global reach into income and they have no need for more investment capital – and yet still have no need to provide an exit for their early-stage investors? Or are they overvalued and afraid that an IPO would devalue the company and provide a poor exit for early-stage investors?

    How do you know when a company gets overvalued? A tell tale sign of overvaluation is when extremely savvy investors try to break up their large amount of shares and sell them to unsophisticated individual investors in smaller blocks (sound familiar?). The IPO process is similar to the distribution process of any business trying to sell product in that it brings products to the retail buyer (or as in this case the retail investor). By breaking down the investments into smaller chunks it enables the seller to sell his investment at grossly inflated prices. As I stated earlier, I was approached several times in the past 3 weeks to buy Facebook private stock and the sales pitch was that I would be buying it pre-IPO and I should get in now. If the company had plans of going public any time soon I promise you that no sophisticated investor would sell today, unless they believed the company was already overvalued.

    The next question revolves around how these sales get executed. I have yet to execute a Term Sheet or a PPM that enabled me to transfer the ownership of non-public shares to someone else without the prior written consent of the Company. Does Facebook have these provisions in their agreements? I can only assume that their attorneys would mandate it. If they do have these provisions, has Facebook provided authorization for early investors to sell their private stock, and why? These questions do not have satisfactory answers and to me (again, with no view of any legal documents) it sounds like it’s a scam or Facebook has no plans on going public and the people in the know, know this fact. If it walks like a duck, quacks like a duck, and looks like a duck, I am betting that it’s a duck.

    Please understand that I am a huge believer in the long term prospects of Facebook and feel that we have only seen the tip of the iceberg from the Company. However, you can talk to investors who made significant amounts of money over individual investments and others who lost everything on the same companies – the question is always one of timing and valuation. All I am saying is for individual retail investors to be very cautious with this type of investment. If this sale of private Facebook stock is possible and if Facebook has authorized these types of transactions, an investor should know to have an attorney review all of the documentation thoroughly to ensure that the transfer of ownership is permitted. Additionally, they should know that the shares being offered are illiquid securities and most likely not be allowed to be transferred again until a public offering (again, seek clarification from an attorney). Also be sure that any private shares you are receiving have piggyback registration rights. For the less sophisticated investor reading this, it is entirely possible for Facebook to go public and not register your shares with the offering. In this case you would not be eligible to sell your shares on the IPO but rather you would have to sell your shares pursuant to SEC rule 144. It is imperative that you understand your rights of ownership. Please understand again, I have not seen any of the documents for these purported sales, but these are things that COULD transpire. Make sure you have strong legal representation specializing in these types of transactions.

    Furthermore, should an investor decide to proceed they should know that the terms should be negotiable because this is a private transaction. The more you buy the more negotiation power you will have over the valuation and business terms. Keep in mind you are doing the seller a huge favor by providing them with liquidity in an illiquid security and as such you should be getting the stock at a significant discount to the Company’s current valuation.

    Understand that my opinions are based on being approached by industry professionals stating they can get stock from early investors. While I can understand how a transaction like this is feasible I do not see how it is likely. I am fully aware of several well-funded companies that have emerged over the past few years that specialize in the secondary market – all of whom claim they have the same ability to provide access to stock in private companies except they allege to procure their stock from the options of ex-employees and other similar means. It would appear to me that this is a much more viable and safe way to procure stock in a private company – and likely at a better valuation.

    I am still waiting for the documents and will reserve my final decision for my personal investing post-review, however in the meantime my advice is, “Buyer beware.” To me this sounds like the typical story of the large, savvy investor pulling the wool over the eyes of the retail investor who will most likely get screwed, at least for the short term.

    For further background (and confirmation) on this topic, check out http://dealbook.nytimes.com/2010/12/03/a-silicon-bubble-shows-signs-of-reinflating/. It’s a great article outlining the possibilities, but in the end it comes down to whether this is a sign of stock owners avoiding the impending “bubble” bursting OR this possibly being an insane opportunity. If you’re presented with the chance to invest in Facebook now, and you decide to move forward, be sure to do your homework, take nothing at face value, and get a great lawyer.

    - Jason Bishara




    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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    Dec 30, 2010
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