How To Purchase Facebook IPO Shares If You Decide To

Everyone’s talking about Facebook’s upcoming IPO. Regardless of if you want to invest, this post should help you understand the IPO process, find out if you’re qualified to purchase Facebook shares, and provide some opinion on the valuation.

To become more familiar with the offering, immediately check out the most recent SEC S-1 filing and the road show video. Focus on the filing, if nothing else check out the: prospectus summary (p. 1), selected consolidated financial data (p. 38), business (p. 84), and description of capital stock (p. 148).

As expected, the video is heavily scripted, biased, and focuses on the potential with their number of users. However, you don’t have to watch all 30 minutes; here’s a link to summarization. Also, if you want to balance out the melodramatic Zuckerburg, glimpse at the Facebook tag on Tumblr.

Facebook’s IPO Process
There are many reason why a company may want to go public, most notably, to raise capital and provide a liquidity mechanism for investors. There are no earnings, cash flow, profitability requirements for a company to IPO (outside of exchange requirements). This means a good IPO candidate can be a new, untested company.

Here’s the Facebook IPO timeline:

  • February 2012: The company files a S-1 with the SEC. The SEC and investors approved of the IPO.
  • April 2012: Facebook chose to be listed on the NASDAQ - getting a pretty sweet deal and will be given the FB ticker.
  • Current Stage: Investment bankers solicit interest from institutional clients during what is called a road show. Right now the price range is $28 to $35 per share. The approximately 337 million shares will bring in $9.4 billion cash at the low end of the range.
  • As early as May 18, 2012: Shares will be priced.
  • Sometime after May 18, 2012: FB will IPO, receiving cash for their shares. Plus, a few of FB’s executives, employees, and relatives will celebrate the NASDAQ opening bell. After which, the shares are open to the public.

The type of IPO auction is important to note. FB will be using the traditional allocation method, while 5 years ago, Google used a dutch auction. This partly decides which retail investors (you and I) will have access to the shares and how shares are allocated.

Participating in Facebook’s IPO
20% to 25% of the 337 million shares could be allocated to brokerage firms like TD Ameritrade, Charles Schwab, E*Trade, or others catering to small investors. Here is the general process to participate:

  1. First thing you should do is call your brokerage house. The brokerage should have an IPO department. This department will first see if your account is qualified, confirm you’ve read the prospectus, and understand the risks. For Charles Schwab, qualifying means having over $100,000 in household assets or having traded more than 35 times in the last year. Sometimes you’ll be asked to fill out an additional IPO form; I know E*Trade does this.
  2. Place a conditional offer to purchase IPO shares. Tell your broker the number of shares you want to purchase and the maximum price per share you are willing to pay.
  3. Once the price is set by FB’s underwriters, everyone has to reconfirm their conditional offer. The window for the reconfirmation is small (sometimes 1 trading day or 8am to 4pm EST) so make sure you check your IPO center and sign up for email updates. You will be able to change the price OR quantity of your conditional offer while the window is open. Remember, this also means changing the quantity to 0.
  4. Distribution of shares will depend on the allocation of shares your brokerage receives, demand for those shares, and finally how valuable you are as a client in terms of length and assets.  
  5. Standard commission rates will apply. You can’t, however, flip the IPO. If you’re planning on selling your shares the first day, think again. The brokerages will be upset and possibly penalize you (refer to your broker’s policy) by freezing your account. Normally, you will have to hold the security for 30 days after the IPO date.

Demand for shares will influence if shares will pop or drop on IPO day. FB is likely oversubscribed, meaning there is high demand and the syndicate of underwriters will not have to support the price. So now let’s talk about one of the factors driving demand, the valuation.

Opinion: FB Valuation
Now that you know if you’re eligible or not, let’s talk about FB’s $100B valuation. Firstly, not many IPOs have been successful (refer to the image).

There is a lot of information and opinions on the valuation. Below are a few points that have influenced my opinion in the recent weeks:

  • There are 2 main sources of revenue for FB: payment integration and advertising. The ability for payment integration has created an opportunity for companies like Zynga to thrive. When you have 3rd party developers building apps, it increases interaction of your platform like it has for Apple. At the same time companies are users to sign-on using FB making the business pervasive like Microsoft. On the other hand, because of the information supplied by users, advertisers can have more targeted campaigns than possible on Google. Both of these have great potential for growth.
  • Zynga and other developers are diversifying onto other platforms. Additionally, many services allow you to sign-on with Twitter instead of FB.
  • It is cheap to start a social network, but costly to run one. More employees, servers, and infrastructure will need to be added in the future, decreasing margins.
  • I don’t like the FB interface. Zuckerburg boasts about FB’s hacker mentality - creating a program with the minimum viable features and letting the user decide if it’s successful. Personally, I think FB needs a much better design. This culture is great when a company is just stating out and the innovative users are excited about the product (see next pt.); however, as the company grows, it should better its products.  
  • As the number of FB users increases, the coolness factor decreases. Many have thought that is the sole reason for $1B Instagram purchase. The market is only going to grow more competitive and so the number of acquisitions will have to increase. That compared with social media fatigue will impact revenues and time spent on FB. On the other hand, the more people on LinkedIn, Twitter, and Tumblr the better the service since people want to connect, follow, and increase their exposure. The more friends you have the less you can interact with each of them and FB is a personal network first.
  • I believe the valuation is too high. You can test your own valuation using this FT valuation tool. Refer to the table below for my logic:

          

  • FB had an awesome move made about the founder and the company: The Social Network. This matters because the glorification of the company has an impact on the oversubscription of IPO shares. People who have never bought an IPO before, will seriously think about participating in this one.
  • Users are important to FB and it’s priced at $1.11 per user and around $1.50 per active user based on a $100B valuation. That is much less than the $33 per Instagram user. Plus, the market potential outside the US is still great. Even in the US, young people create accounts and use them almost as soon as their born.

All in all, I may participate in the IPO if I’m confident the pop on the first day of trading will be large enough. For that to materialize, the shares would have to be priced at the very bottom of the range. At the same time, I believe the shares will drop significantly in the short term (60 days or less) presenting a buying opportunity well below the IPO price. Furthermore, in the next five years, the market capitalization has the potential to reach Google’s size.

I’ll be posting my thoughts and final decision on Twitter as the IPO date moves closer. Tweet me and let me know what you think. Also, read the investment disclaimer.

*Update 5/15*: Shares are 25 times oversubscribed according to a recent NYT Dealbook article. Subsequently, FB is raising their price range to $32 to $38.

Additionally, Bloomberg predicts online advertising to grow to $10 billion within the next year. Plus, FB is planning on adding diversity to their company by searching for female executives. The changes in management will be announced after the IPO.

Finally, today is the last day to decide if you would like to purchase IPO shares.

Technical Interviews: Valuation Methods

ValuationThere are four valuation techniques I’ll cover: comparable companies, past precedent analysis, discounted cash flows, and leveraged buyout. Other valuation methodologies include, liquid valuation, replacement valuation, sum of parts, M&A premium analysis, and future share price analysis. In this post I’ll introduce and explain the common valuation metrics, comparable company analysis (trading comps), and past precedent analysis (transaction comps).

Valuation Metrics

I discussed the calculation of Enterprise Value and Equity Value in my previous Technical Interview post. Below are the common valuation metrics used by bankers when comparing one company, business segment, or asset to another similar one. Moreover, each of the valuation metrics has financial and business drivers.

P/E (Price/Earnings): This is the most commonly known multiple. The ratio compares the price of one share of common stock to annual earnings per share. This metric is depend on a firm’s capital structure, meaning the ratio would theoretically be higher if the company was more leveraged. It is important to note that P/E ratios are only relevant when compared companies in the same industry.

Enterprise Value/EBITDA and Enterprise Value/EBIT: These are capital independent metrics, allowing for direct comparison of different firms. These metrics is the most commonly used by bankers.

P/BV (Share Price/Book Value): Popularized by Benjamin Graham, this ratio is useful for valuing companies that have large asset bases.

Additionally, there are industry group specific valuation metrics. For example, for RIETS there is Share Price divided by Million Cubic Foot Equivalent and EV/Pageviews for technology companies.

Interview Questions:

Why don’t bankers use Equity Value/EBITDA? You never use Equity Value/EBITDA, but are there time when you might use Equity Value/Revenue?

These two similar questions are commonly asked. There are enterprise value multiples (e.g., EV/EBITDA, EV/EBIT, EV/Sales, and EV/Unlevered FCF) and there are equity value multiples (e.g., Price/EPS, Equity value/BV, PEG ratio). If you switched the ratios (i.e., Equity Value/EBITDA), it would be like comparing apples and oranges since equity value doesn’t reflect a company’s entire capital structure.

Why does Buffet prefer EBIT multiples to EBITDA multiples?

He dislikes EBITDA because it excludes the often sizable Capital Expenditures companies make and hides how much cash the are actually using to finance operations. Also, some industries have large gaps between EBIT and EBITDA (e.g. financial services).

Why wouldn’t you screen for both equity value and revenue, or both equity value and EBITDA?

The problem is that you “artificially limit” your multiples. For example, screening for companies over $5 Billion market caps and over $1 Billion in revenues would limit your search to firms with greater than 5x multiples. The same logic is pertinent for equity value and EBITDA. 

Who has a higher P/E, Apple or Caterpillar? Why?

Caterpillar is currently at 15.8 and Apple is currently at 15.35, even though CAT is manufacturing and AAPL is technology. Comparing P/E ratios of companies in different industries is not relevant. The ratio is only relevant for comparison intra-sector.

Comparable Companies Analysis Interview Questions

How would you explain trading comps?

Comparable company analysis can be used to value a company, division, business, or collection of assets. The companies selected have similar business and financial drivers.

What process would you complete a comparable companies model?*

  1. Select the universe of comparable companies
  2. Locate the necessary financial information
  3. Spread key statistics, ratios, and trading multiples
  4. Benchmark the comparable companies
  5. Determine the valuation

What are the strengths and weaknesses of this methodology?*

Pros

  • Market-based – information used to derive valuation for the target is based on actual public market data, thereby reflecting the market’s growth and risk expectations, as well as overall sentiment
  • Relativity – easily measurable and comparable versus other companies
  • Quick and convenient – valuation can be determined on the basis of a few easy-to-calculate inputs
  • Current – valuation is based on prevailing market data, which can be updated on a daily (or intraday) basis

Cons

  • Market-based – valuation that is completely market-based can be skewed during periods of irrational exuberance or bearishness
  • Absence of relevant comparables – “pure play” comparables may be difficult to identify or even non-existent, especially if the target operates in a niche sector, in which case the valuation implied by trading comps may be less meaningful

Why would a company with similar growth and profitability to its comparable companies be valued at a premium?

This can be due to a number of recent news events (e.g., winning a major lawsuit, gaining a competitive advantage, and repurchasing stock).

Past Precedent Analysis Interview Questions

How would you explain past precedent analysis?

The best comparable acquisitions typically involve companies similar to the target on a fundamental level (i.e., sharing key business and financial characteristics)

Likewise, under normal market conditions transaction comps tend to provide a higher multiple range for 2 reasons: 1) the buyers generally pay a premium and 2) the strategic buyers often have the opportunities to realize synergies.

What process would you complete a past precedent analysis model?*

  1. Select the Universe of Comparable Acquisitions
  2. Locate the Necessary Deal-Related and Financial Information
  3. Spread Key Statistics, Ratios, and Transaction Multiples
  4. Benchmark the Comparable Acquisitions
  5. Determine Valuation

What are the strengths and weaknesses of this methodology?*

Pros

  • Market-based – analysis is based on actual acquisition multiples and premiums paid for similar companies
  • Current – recent transactions tend to reflect prevailing M&A, capital markets, and general economic conditions
  • Relativity – multiples approach provides straightforward reference points across sectors and time periods
  • Simplicity – key multiples for a few selected transactions can anchor valuation
  • Objectivity – precedent-based and, therefore, avoids making assumptions about a company’s future performance

Cons

  • Market-based – multiples may be skewed depending on capital markets and/or economic environment at the time of the transaction
  • Time lag – precedent transactions, by definition, have occurred in the past and, therefore, may not be truly reflective of prevailing market conditions (e.g., the LBO boom in the mid-2000s vs. the ensuing credit crunch)
  • Existence of comparable acquisitions – in some cases it may be difficult to find a robust universe of precedent transactions
  • Availability of information – information may be insufficient to determine transaction multiples for many comparable acquisitions
  • Acquirer’s basis for valuation – multiple paid by the buyer may be based on expectations governing the target’s future financial performance (which is typically not publicly disclosed) rather than on reported LTM financial information

More Information on the Subjects

Like in prior posts, I like to supplement my writing with additional outside sources.

  1. Here is a great explanation and illustration of the valuation multiples in table format.
  2. For more on the valuation methods in PowerPoint format, check out this BU pdf.
  3. Interested in watching a YouTube video on valuation? This guy, Hamilton Lin, is a Boss!
  4. Finally, check out a few more interview questions on ibankingFAQ.

Other Common Questions

How would you present these valuation methodologies?

Presented with low, high, median, and mean markers. Here’s a picture:

                                            Valuation Range

How would you value an orange tree?

The same way you would value a company. Looking at comparable orange trees (relative valuation) and the value of the tree’s cash flows (intrinsic valuation).

What do you actually use a valuation for?

Usually you use it in pitch books as well as in client presentations when you’re providing updates and telling them what they should expect for their own valuation. It’s also used right before a deal closes in a Fairness Opinion.

Two companies have the exact same financial profile and are bought by the same acquirer, but the EBITDA multiples for the transactions are 2x different – how could this happen?

One could be because of differences in the way the companies were sold differed. For example, an auction with more bidders will probably fetch a higher valuation than a closed bidding system. Also, recent company news could also be an influential factor.

Walk me through how you would “calendarize” financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.

TTM = Most Recent Fiscal Year + New Partial Period + Old Partial Period

Take the company’s Q1 numbers, add the most recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year. For US companies you can find these quarterly numbers in the 10‐Q; for international companies they’re in the “interim” reports.

Next time, I’ll write about the discounted cash flows valuation method. As always, feel free to get in touch with comments or questions.

——————————-

* Source: Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions (Wiley Finance), 2009 - I highly recommend this book. I will be writing a review and posting my notes on this book shortly.

Shark Tank Valuation Observations

I like ABC’s Shark Tank. Especially now that Mark Cuban is a permanent member! I enjoy listening to the entrepreneurs’ ideas while speculating as to the investment and stake I would make in the company. Moreover, I think it is great seeing the people’s hustle and dedication to their companies. As Steve Jobs said, “Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do.”

The show is also relevant to me personally since the startup I am involved with recently went through the process of raising an additional $125,000 in seed funds. However, just as in the show, negotiating a fair valuation for the company can be a subjective issue. While there are many variables that influence a startup’s valuation, I personally believe the offers on Shark Tank are too low. There are several reasons the Sharks get better deals. All of them have to do with the way the show is organized.

First, there are only five investors (six with Cuban). At first glance, the viewer and entrepreneur would think this would facilitate competition in favor of the entrepreneur. However, this is rarely the case since each of the investors specialize towards a certain type of investment. Additionally, the investors have the option to collude on deals, and this always puts extra pressure on the business owner, while limiting their options.

Secondly, there is a steady steam of deals coming into the Tank. I know the executive producers of the show choose the contestants, but the qualifications are consistent and the applicants almost endless. Since the Sharks aren’t worried about deal flow, they can be more selective and demand a longer track record.

These are the reasons I believe cause entrepreneurs to, on average, receive below market level valuations. To clarify, all of the deals made by the Sharks aren’t cheap. Many of the deals made are with entrepreneurs in the manufacturing and retail space who haven’t run successful startups in the past. These owners might not have the opportunities to grow and build their businesses if it wasn’t for the investors’ money, advice, and connections.

I am looking forward to the next season since the permanent addition of Cuban to the team will be a good thing for the entrepreneurs. Cuban has larger pockets than the other Sharks and has been more generous with his offers (i.e. the firefighter who invented interchangeable hoses). Also he is less prone to collude since he can afford the increased risk.

Finally, if you like this show, then you’ll definitely enjoy U.K.’s Dragon Den. The investors are more successful and far more blunt. This combination makes the show educational and funny.

Financial Modeling for an Early Stage Startup

In an earlier post, I informed you that my startup is currently raising capital. In this post, I talk about my process in creating our financial model and provide a working copy of the model below. Because of my educational background and experience in finance, I was responsible for creating the financial model. However, I quickly learned it very different from investment banking modeling.In i-banking, the company you are valuating has a financial history, in this case, I had to start from scratch.

I began with a little research, hoping for an Excel template that could act as a foundation for the formatting. I soon found out that resources on startup financial models was limited. There were a lot of websites out there trying to persuade me that creating a financial model was important (tell me something I don’t know), but didn’t explain the steps to build one. Regardless, here are a couple of websites I found helpful:

  1. This website has a ton of Excel templates. I used it to calculate my FCFs (free cash flows)- http://www.exinfm.com/free_spreadsheets.html
  2. Discusses interesting accounting measures needed for SAAS (software as a service) companies- http://www.beyondvc.com/2009/12/startups-and-financial-models-for-saas-companies.html
  3. The most popular slideshow I found on the explaining the basics of a financial model- http://www.slideshare.net/botteri/cloudonomics-101-creating-a-financial-plan-for-your-saas-or-cloud-computing-business
  4. A good source for more templates (look at the comments) - http://www.finance30.com/forum/topics/enterprise-software-company?commentId=1987892%3AComment%3A970711
  5. A more professional article on SAAS financials- http://www.sterlinghoffman.com/newsletter/articles/article339.html

I found this information with a few searches on Google. However, after reading them, I still had no idea how to create one. It was then that I decided to stop looking and start building. Here are the steps I took to create my model:

  1. Started with the Income Statement for my first year. I took the total revenues by each source and subtracted them by my sales and administrative costs, research and development costs, and sales and marketing costs. The difference was my earnings before income and tax (EBIT). This step really allowed me to get familiar with all the facets of my company.
  2. Worked on the assumptions section. This is where my investment banking background came in handy. By discounting my user-base and costs over over a span of 3 years, I was able to get a conservative estimation of my future growth. (Please look at the “Working Excel Template” at the end to get more information on this section.) My assumptions are unique for my industry and product.
  3. Then I created an expected income statement, an upside income statement, and downside income statement. The difference in degree is reflected in the assumptions section.
  4. I added two graphs: expected earnings (3 lines- expected, downside, and upside) and revenue by source.
  5. Lastly, I created an exit opportunity worksheet. I calculated free cash flows and internal rate of return (a common measure VCs use to calculate return on their investment).
  6. I also added a comparable analysis section to the same exit opportunity worksheet. In it I chose comparable public companies to give the venture capitalists something to drool over.
  7. I ended by formatting all the user numbers in blue, calculations in black, and averages in brown. Also, I changed the theme to reflect our PowerPoint slides.

Without further delay, here is a link to the model: http://www.mediafire.com/view/?nbm1a130o3vvd5v

The file is titled: “Working Excel Template”. Hope this post was helpful. Enjoy and I look forward to any questions, comments, and suggestions.

Disclaimers:

  • Not all of the number values are accurate. This is partly due to me wanting to stay anonymous.
  • Each start-up will vary (by stage, industry, and company)
  • The EV values are incorrect
  • Download the file so that you can see and edit the model