An old "Far Side" carton by Gary Larson has pioneers cowering as Indians send flaming arrows into their circled wagons. "Can they DO that?" asks one of the hapless mule skinners to another.
I think about this today when hearing about Mark Zuckerberg, the 26-year-old-founder of Facebook, a social net-working site with more than 500 million registered users. Zuckerberg is suddenly worth roughly $7 billion, which makes him richer than Apple's Steve Jobs. "Can they DO that?"
What financial alchemy can make this happen? I wondered about this a few years ago when a friend of mine, who was in Google early at $4.00 a share, said, "Let me show you how easy it is to make $10 million."
Fundamentally, it's the work of a concept called "markingâ€”to-market." This means that the entire company is valued based on the price of the most recently sold piece. Someone starts a company with $100,000 and owns 100 percent. The company gets some traction and credibility and soon someone else is investing $1 million for a10 percent share. If 10 percent is worth $1 million, the entire company is worth $10 million and the founder who still owns 90 percent is suddenly worth, on paper, $9 million. You can see where this is going.
A few years later, after several rounds of outside investors plowing ever-larger amounts into the company for ever-smaller percentages, we can have the original founder still owning as much as 50 percent. However, if the most recent buyer paid $100 million for a 10 percent share, then the entire company is now worth $1 billion dollars.
The founder who owns 50 percent is worth $500 million. Beyond the founder, previous outside investors, who still own 40 percent, are suddenly worth $400 million in this example. The earliest outside investor who paid $1 million for 10 percent is now worth $100 million. And so on... .
In 2007, Microsoft paid about $250 million for a 2 percent interest in Facebook. This effectively made the entire company worth over $12 billion. Zuckerberg still owned about 20 percent, which made him worth about $2.5 billion at the time.
But wait. There's more. Today, Facebook's shares are owned by enough people and institutions so that there is a market for them. Not a stock market, like we little people get to access, but one where a large block of shares can be traded among insiders and sold to outsiders.
This shadow market can exist as long as there are fewer than 500 shareholders. Apparently, the prices that Facebook shares trade at today have created a marked-to-market value for the entire company of $33 billion. In this shadow market, Mark Zuckerberg has presumably managed to sell enough of his shares so that he can donate $100 million to the Newark, N.J., school system.
At the point where shareholders number more than 500, the company will be forced to become a public company. As a general rule, the act of "going public" imparts a four times multiplier to the company's value. In other words, the value of a company while private (meaning less than 500 shareholders) suddenly becomes four times more valuable when it goes public.
Keep in mind the marked-to-market concept: what the public will pay for the piece of the company that goes public will determine the value of the entire company.
Remember what happened to Google -- or Apple in the beginning? Small investors, who were smitten with irrational exuberance, just want a piece of the action. They really didn't care what they paid for shares. The "greater fool theory" runs amuck.
Google, which is owned by a relatively small amount of public shareholders, is worth $160 billion thanks to how the world works. About 30 percent of that figure is still owned by the original founders.
Who knows if either of these companies will ever generate future profits that will justify these values. At this point, it's in the realm of financial theater. Some investments are worth watching for their sheer entertainment value, and Facebook could be one of them -- plus, the story is coming to a theater near you.