Excerpt from 'The Facebook Effect': Playing Hardball with Big Investors

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With nearly 500 million users, Facebook has grown from a college experiment into one of the world's most frequently visited web sites. But the company's meteoric rise has not been without controversy. Over the last month, Facebook CEO Mark Zuckerberg has found himself in the middle of a privacy storm. Government officials, privacy experts and ordinary users have complained about the site's complex settingsand the way in which the service shares personal information across the web, prompting the company to announce new, simplified settings last week.

Now that the backlash has died down, Zuckerberg and his investors can refocus their attention on their main goal: an initial public offering at a multi-billion dollar valuation, perhaps as early as 2011.

For his new book, The Facebook Effect (to be released on June 8 by Simon & Schuster), author and veteran technology journalist David Kirkpatrick was granted unprecedented access to the company's top executives. Kirkpatrick traces Facebook's wild ride from a Harvard dorm room to the corridors of a Silicon Valley powerhouse.

From the beginning, Kirkpatrick writes, Zuckerberg has insisted that Facebook is not for sale -- it spurned a $1 billion buyout offer from Yahoo (YHOO) in 2006. Instead, Facebook has stockpiled cash through a closely-held venture capital process and strategic partnerships. Perhaps no development was as crucial as its high-profile October 2007 tie-up with Microsoft (MSFT), which valued that social networking start-up at a cool $15 billion, despite little revenue to speak of.

In the following excerpt from The Facebook Effect, Kirkpatrick takes readers behind the scenes of the Microsoft deal as Facebook seeks to maximize its valuation and Microsoft refuses to let Google (GOOG) outbid it for a stake in the promising start-up. -- Sam Gustin

Chapter 12: $15 Billion

"A trusted referral is the holy grail of advertising."

By DAVID KIRKPATRICK

Opening Facebook up to everybody had been a huge success. By the fall of 2007 more than half the site's users were outside the United States. The explosive international growth was a powerful sign of Facebook's growing universal appeal, since the company had done nothing to make it easy for non-Americans to join. All the text remained completely in English, for one thing.

But the growth also presented a serious business problem. Facebook had to start figuring out how to make money-providing service to people all over the world was expensive. All the ads were aimed solely at Americans, which meant that Facebook was not generating any appreciable revenue from more than half its users. The advertising deal Facebook had signed with Microsoft a year earlier only applied inside the United States. If Facebook was going to take advantage of its newfound global presence, it needed a partner to help it sell display advertising internationally. Microsoft had made it plain it would love to be that partner, extending its U.S. deal to a global one.

Zuckerberg had always been blasé about advertising . But Facebook now had 50 million active users and the platform had transformed it into an industry darling. The company had to find a way to pay for it all. Hundreds of thousands of new users were joining every week. And Facebook continued to build its infrastructure based on the assumption it would be much, much larger in the future. That meant spending millions of dollars for new servers. If he had to have ads, Zuckerberg hoped to develop a new kind that would work uniquely well on Facebook, ads that wouldn't interfere with a user's experience. The last thing Zuckerberg wanted was for it to feel like watching network television, where the show is routinely interrupted by irrelevant and inane advertising.

The U.S. ad deal gave Microsoft the exclusive right to sell banner advertising on Facebook. That had to change. Relying primarily on Microsoft for the lion's share of revenue was precarious. Facebook needed its own self-managed streams of revenue.

Separately, Zuckerberg and Facebook's board decided it was time to raise more money. Peter Thiel in particular wanted to do it that fall. Thiel has a refined nose for the twists and turns of the financial markets. Stocks were at levels not seen since the dot-com bubble and investors were feeling buoyant. Facebook's reputation and growth had been transformed by f8 and the platform launch, and it was time to take advantage of enthusiasm among investors. But Thiel also knew that if they went out asking investors for money, someone might try to buy the entire company. To Thiel and Jim Breyer that was an appealing idea, but it horrified Zuckerberg (whose two unfilled seats on the board of directors remained in his control as a form of horror insurance).

The CEO asked Van Natta and his newly hired chief financial officer, Gideon Yu (who had been CFO at YouTube), to see what kind of interest they could drum up for a small stake in the company. Yu now says he thought Facebook might be able to get investors to buy stock at a valuation of about $4 billion. That would have been a huge leap. A little more than a year earlier, its third round of financing (called Series C) had raised $27.5 million, valuing Facebook at $525 million.

But this company, as usual, didn't conform to the usual expectations. Several venture capital and private equity firms were willing to buy a chunk of Facebook at a $10 billion valuation. That was eyeopening to Yu. He'd clearly been thinking too small. But Zuckerberg wasn't satisfied. He thought the company was worth $20 billion, says another confidant. He and Van Natta decided to try for $15 billion. Sure enough, they found interest from several parties, but not enthusiasm.

Nobody would invest at this level without doing some serious negotiating on the terms. "We found where the market was," says Yu. "We were going to be able to get a deal done at $15 billion."

This was right about the same time that talks with Microsoft about an international ad deal began in earnest. The software giant also wanted to hold on to its U.S. deal with Facebook, but Microsoft executives felt they couldn't let it stay the same. It needed to renegotiate the deal as much as Facebook did. Microsoft was losing about $3 million a month on the U.S. ads. It was putting the lion's share of its banner ads on Facebook pages that displayed photos, but people just didn't much notice ads in that environment. The price Microsoft thus could charge advertisers was low. Yet it had agreed to pay Facebook a guaranteed minimum amount-around 30 cents for every thousand page views, regardless of what it was getting from advertisers.

Everything Microsoft was doing in online advertising was fundamentally a response to Google's growing power. Google search ads were garnering over half of all online advertising dollars, even as the increasingly profitable search giant was starting to toy with other sorts of software that directly competed with Microsoft's core PC products. To fight back and defend its turf, Microsoft was now going head to head with Google across the board in online advertising. As part of this effort, it was investing billions of dollars to improve its own online search software. Separately, it had in May made its biggest purchase ever-paying $6 billion for aQuantive, which distributed advertising across the Internet. Now that it owned this distribution engine, it badly needed additional inventory to sell through it.

Microsoft CEO Steve Ballmer was fed up with losing deals to Google. He had recently lost both of the industry's two biggest partnership opportunities after coming exquisitely close to agreement. Each time, Google swooped in at the last minute and stole the deal away. Ballmer had flown to New York in December 2005 to negotiate a major ad partnership with Time Warner's AOL. He left town thinking he had a deal. Google unleashed its ad team headed by Tim Armstrong and came in with a better offer in days and sealed a contract with a $1 billion investment in AOL that valued it at $20 billion. Then in August 2006, Microsoft had a deal with News Corp.'s MySpace and was poised to guarantee $1.15 billion, according to one of the deal negotiators. Google pounced at the final hour and won with a three-year guarantee to News Corp. totaling about $900 million. News Corp. apparently wanted the status of partnering with Google so much it was willing to give up revenue to do it. Microsoft had been further galled when Google swept up Internet banner advertising network DoubleClick for $3.1 billion in early 2007. This time, Ballmer was resolved it would not happen again.


From THE FACEBOOK EFFECT by David Kirkpatrick. Copyright © David Kirkpatrick. Reprinted by permission of Simon & Schuster, Inc.

Postscript: As the world would soon learn, Ballmer wouldn't be outfoxed by Google again -- at least when it came to cozying up to Facebook. Microsoft ultimately invested $240 million at a $15 billion valuation for a 1.6% stake in the social networking site. -- SG
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