Rosetta Stone – Bad Economics and Unintelligent Marketing

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“The only useful financial innovation is the ATM.” I couldn’t disagree more.

The most recent financial crisis spurred cynicism and skepticism regarding financial innovation.  Paul Volcker, the former Fed chairman, in an interview said that the only useful financial innovation he can think of is the ATM.   Many people believe the financial crisis was caused by Wall Street, thus picturing all financiers with big horns and devilish appetite to dominate the world without any positive contribution to society.

I couldn’t disagree more.

In times of crisis, we become shortsighted and we wipe out everything rational from our minds and focus on finding a scapegoat to blame.  If it is true that financial innovation is the source of all evil, causing bubbles and crashes, then if we go back in time when financial systems did not exist, it is logical to expect to see no bubbles.  However, history proves us wrong.  The most famous one of all is the tulip bubble of 17th century in Netherlands which had nothing to do with financial markets, but everything to do with human insatiable appetite to profit from pure speculation.  At the peak of the tulip mania, a single tulip bulb sold for 10 times the annual income of a laborer. When the bubble finally collapsed, many men lost their fortunes overnight.  

We do not need to go that far back in history to find more examples of crises unrelated to financial markets.  Over 30 million people died of starvation in the Chinese experiment to collectivize farming.  Chairman Moa did not rely on financial markets to starve millions of people to death.

Post the financial crisis, support for capitalism has been falling all over the world.  However, capitalism is not a static phenomenon.  It is dynamic and it is constantly being updated through innovation.   Without innovation, capitalism will wither and die.  Financial innovation allowed an average person to become a home owner.   Today, that innovation continues to bring up new ways to allow capitalism to achieve society’s goals. Three such examples are: (1) The Benefit Corporation, (2) Crowd Funding, and (3) The Social Impact Bond.

The Benefit Corporation is an entity that combines charity with profit maximizing motive.  It is a new class of corporation which has a social mission in addition to maximizing profits for its shareholders.  This innovation gave birth to Grower’s Secret, a fertilizer company, which has the mission to restore the health of our oceans caused by fertilizers washing into the waters.

Crowdfunding remains my favorite recent innovation.  The basic concept is that it allows people who believe in an idea to fund entrepreneurs who want to make that idea reality.  Next time you said “I wish I had a robot who answered all my work emails” you’d be able to check on a crowdfunding platform if an MIT geek has figured out how to make that happen – and you can invest in his idea and become a shareholder.   Crowdfunding is used to support not only for-profit-business ventures, but also for civic projects, disaster relief, political campaigns, and to support artists by fans.  An example of such platform is Wefunder (www.wefunder.com) , which helps crowd investors purchase stock for as little as $100 in the most promising new businesses around the country. On the other side, it helps startups raise funds from their most passionate users who provide product feedback, marketing evangelism, and business connections.  

The third is the Social Impact Bond. It is a bond in the traditional sense, however, repayment to investors is contingent on the achievement of specified social outcomes.  The idea is to let a free enterprise solve a social problem.  One example is the social impact bond issued by the U.K. Ministry of Justice to finance a group of activists that they hoped would help solve the recidivism problem of the U.K. prison system.  They raised £5 million from social investors who would make a profit only if the recidivism problem was mitigated as defined by the bond contract.   In the U.S. MA and NYC are experimenting with social impact bonds and interest in this type of funding is spreading across the country.

While I do agree financial reform is necessary, we should not blame all our miseries on financial markets, and we should not understate the great benefits of financial innovation.   If we describe humans as a collection of emotions and impulses – then wise regulation needs to address to restrain the animal spirits in us and help activate the circuits in our brains that will limit our tendencies for fraud, mismanagement and unethical behavior.  However, we should allow for innovation to continue to spur economic growth.  After all, bubbles are caused by investors’ animal spirits; innovation simply provides more tools to our animal spirits to act irrationally and create bubbles. With our without financial markets, human nature will find ways to create crises.  On the other hand, financial innovation can retool capitalism to solve world problems.

How did Apple get away with buying the iPad trademark for only $55,000?

Recent news developments in the iPad trademark case reveals that Apple only paid $55,000 for the rights to use the iPad name in mainland China.  While these rights are being contested by Proview, the company owning the name, I am puzzled by the valuation.

Typically, trademark is valued by the premium price charged for a product over that of its competitors.   It is estimated that Apple sold more than 500,000 iPads in China this past quarter alone (not counting the gray market sales - source:computerworld.com).  Assuming a conservative price premium of $200 (iPad’s average price in China is $900) that equates to at least $100 Million in premium in one quarter alone or $400 Million in a year.  While more assumptions are needed to calculate a true trademark value, a rough estimate will put the true value closer to the $2 billion asked by Proview than the price tag of $55,000 paid by Apple.

It may very likely be that Proview got the worst end of the deal, however, there is typically no legal ramification for asking too low of a price when both parties acted in good faith.  However, Proview is challenging Apple on the validity of the licensing agreement - whether Proview’s subsidiary, which signed the deal, had the contractual rights to do so.

How did Apple get away by paying so little for the deal?  Well, Apple never approached Proview. Proview, when signing the deal, had no knowledge who the ultimate beneficiary was. Apple set up a special purpose company -  Application Development Ltd (IPADL) – to negotiate the deal on its behalf without revealing to Proview Apple’s identity.  This move is not unusual for a company when the mere fact of the deal will signal the market about its upcoming strategic moves and will threaten its competitive advantage.  On another hand, it will help the negotiating terms when the two parties are on uneven grounds – that is when each party values the deal differently.  In this case, Proview’s blindness to Apple’s identity drove the deal valuation based on Proview’s prospects of monetizing the iPad name – hence, one can argue that without Apple’s marketing prowess, the iPad trademark would have been worth only $55,000.  That is the economic value of the trademark to Proview.  Had Proview known of Apple’s identity, it would have been bid up the deal to extract the economic value created by Apple.

 

There is nothing illegal or unethical in Apple keeping Proview in the dark about its identity.  The deal should have reflected the fair economic value of the trademark, and not the strategic value to Apple.  A fresh way to assess the fair value is to ask “but-for the Apple deal, how else could Proview have monetized the trademark and how much value would the alternative have created?” 

If the courts find the contract not to be valid, then the parties have to agree on what the terms of the deal should have been.  Proview seems to be inclined to ask $2 billion, the trademark value created by Apple – and Apple will have to argue that the fair economic value is perhaps closer to $55,000 and that Proview should not be entitled to extort value created by Apple.

Of course, Apple’s argument may only prevail if the courts determine the parties acted in good faith. When ‘bad faith’ is assumed, not only Apply may have to pay any profits made on its iPad sales in China, but also punitive damages.

 

While Apple’s trademark dispute brings up interesting valuation dilemma, it also tells us the benefit of setting up special purpose entity to negotiate licensing deals without revealing the company’s identity.  Next time you are considering licensing IP rights, consult your lawyer about the benefit of special purpose vehicles.

Is Facebook overvalued at $100 billion? The short answer is Yes.

While Facebook’s (“FB”) valuation has attracted a great deal of attention, it remains a mind twisting mystery how we continue to overvalue companies when obvious warning signs exist. 

A typical valuation is based on a combination of market value comparisons of similar companies and the company’s potential to generate future earnings.   It requires sophisticated spreadsheets with projections and value comparisons to arrive at what may seemingly be a reasonable price to pay.  But, when the assumptions used become outrageously flawed, so does the so-called “vetted” and “reasonable” valuation.  How many of us still remember the dot.com bubble of a decade earlier?  As a valuation analyst, I actually did see those “vetted” valuations that priced companies at outrageous margins – all were done in fancy spreadsheets – but had one thing in common: outrageous assumptions.

Without getting deep into the spreadsheet assumptions, I will offer a few simplistic ways to assess Facebook’s valuation:

1.       Look at the stock performance of RenRen (the Chinese Facebook) and FriendFinder (another social networking platform) since their IPOs less than a year ago.  RenRen lost over 60% of its IPO price in a few months and has been unable to recover since.  On the other hand FriendFinder has lost over 80% of its value and is now trading under $2 per share.

2.     Calculate the value per active user across social platform companies.  For example, LinkedIn with 135M users is trading at a value of $63 per user, whereas FB with 845M users and $100B valuation is valued at $118 per user.   

3.    Compare FB to Google.  Google’s market cap is $200B and with revenues of $38B, that makes $1 of Google revenue worth $5.25 to an investor.  While FB at $100B in valuation and $3.8B in revenue makes $1 of FB revenue be worth $26 to an investor.  Granted that FB has potential for growth – however, the inherent assumption is that FB has to grow organically at least 20% every year for the next 10 years to justify its valuation.  While 20% may not be high for an early stage company, I have never seen a company do so for 10 years straight.

4.     Assess the disruption factor.  Given the unproven nature of the social networking platform as a revenue hotbed, a fresh way to assess its potential value is by asking a simple question – “If FB ceases to exist, how will that impact consumers of the company vs. if Google ceases to exist?”  Reframing the valuation paradox in terms of disruption factor can shed light into the potential value.  Since a fundamental tenet of valuation is value comparisons across competitors, in an unproven industry it may be hard to do so – however, we can get a glimpse of the truth by assessing the disruption factor.  If you think Google will disrupt your life far more than Facebook, then Google has more intrinsic value than FB.  Over the long term, valuations tend to converge to company’s intrinsic value and therefore, it can be a good yardstick to measure current valuations against.  With this rationale, each $1 of FB revenue will be worth LESS to an investor than each $1 of Google revenue in the long-term.  Since today it is the opposite, this phenomena will cause FB’s market cap to come down over time.

5.     Review recent valuations of FB. Just a year ago, FB was valued at $50B and only 2 years ago at $10B.  While FB’s successful monetization of its user base can explain the valuation change since 2 years ago, however, I can hardly recall anything significant changing in the past 12 months to warrant doubling its value.  This may be indicative of the IPO mania driving its valuation to the roof.

While any of these factors in isolation will not be sufficient to draw any conclusions, there are too many warning signs to be ignored.  Sometimes the sophisticated spreadsheets can miss the target when the assumptions go unchecked.