Venture capitalists must know some math that I don’t know. There is lots of discussion right now about the valuation of facebook.

Lets review what we know;

• Lots of people use facebook. LOTS. More every day.
• The people do not pay for this.
• The people do not want to see advertising, and don’t click on it.
• It costs money to give people a free service. LOTS. More every day.

And what have people been saying about what facebook is really worth?

• When Microsoft invested $240 M in facebook in 2007, it valued the company at $15 “B” for Billion dollars. (although it turns out Microsoft got some sweet preffered shares so maybe its wasn’t quite that high.)
• facebook CEO Mark Zuckerberg recently rejected funding at a $4 B valuation
• Facebook shares that change hands privately are reported to do so in the $2- $3 B range
• Word is that Mark has another offer for financing at the bottom end of that range, $2 Billion.

Now, I know that venture capitalists have their own math and process.

But if I were to give facebook $4 B of my money, I’d expect a 15% return on it. So I’d want a cash flow of about $600 Million a year. If I saw that cash flow, I’d say to myself “Yep. Thats worth the $4 billion I paid.”

No, No! The venture capitalists say. We’re not giving them $4 Billion dollars- we’re giving them $100 million dollars, and saying that the company is worth $4 billion as a way to determine what percentage we get, and we’re factoring in a higher rate of return for all the risk we’re taking. (Brave souls these venture capitalists, but they do need to be rewarded for such bravery.)

Ah. But how are you going to make your money back?

“With the IPO. Then the investors will pay the 4 billion, and we’ll cash out.”

Which investors? “Main St.” – maybe your pension fund. Only problem is that after you buy the stock in the IPO, there is no IPO in the future. So then facebook actually has to make the half a billion dollars a year plus profit for you to get a return on your money. Hmmm. I wonder if the market is really going to pony up $4 billion. There has been some stuff about the economy, and over valuation of things in the news recently.

And when will the huge profits start rolling in? Unclear.

In my humble opinion, if you have 200 million people using your service, and you can’t make a pretty solid profit, you need to reevaluate what you’re doing. Don’t tell me that you haven’t reached critical mass yet.

Facebook is currently some new form of venture capital transfer system- it takes investors money, divides it by 200 million and gives lots of people a really cool website to go to and talk to their friends.

“But this is social media- its new!”

Riiiight. I recall hearing the same sort of thing during the last tech bubble.

I think facebook should be rightfully proud of the enthusiasm their users have for their service. But it’s a company, and it’s a business, and I STILL don’t see the four billion dollars yet.

UPDATE 2011- Kudos to Facebook- rumors are that they are on track to do $2B in earnings- this means in fact they are worth more than the $4 Billion discussed in this post in 2009. But AMAZINGLY now people are throwing numbers like $100 BILLION as Facebooks value now. The multiple just grows to eliminate any reasonableness I suppose (you can just substitute the new numbers into the above). It will be interesting to see where we are at in 2012 when current speculation is that Facebook will go public. Perhaps I underestimate Facebooks ability to simply have every person on the planet signed up, and capture some insane percentage of all advertising and media budget…