Financial wrinkle lost ConnectU some Facebook settlement dollars

Now we know a little more about why ConnectU tried to get out of its “$65 million” settlement with Facebook last summer and why it’s still suing its former lawyer.

Back in 2004, you’ll recall, the company accused former contractor Mark Zuckerberg of stealing ideas and code from it and then launching his own college-focused social network, Facebook. After a series of lawsuits, ConnectU settled for $20 million in cash and 1,253,326 in common stock, according to new information dug up by the Associated Press last night. Turns out, that stock turned out to be worth $34 million less than ConnectU had assumed at the time of the settlement.

It’s the latest news tidbit in a never-ending story of intrigue and lawsuits surrounding Facebook’s founding. It touches on another issue people feel very strongly about: whether or not Facebook deserves the “$15 billion” valuation Microsoft gave it when investing two years ago.

Last March, the company learned that Facebook actually valued its common stock at a quarter of the price implied by the Microsoft investment. This meant ConnectU’s share of stock was worth $11.25 million instead of $65 million. ConnectU says it felt that Facebook had committed “fraud” because ConnectU had assumed it was getting the higher stock value, based on Facebook’s own press releases about its funding. When ConnectU tried to get out of the settlement last summer, the judge said no. This is why ConnectU is now in court with its former lawyers, Quinn Emanuel (the one that recently claimed to have won the $65 million from Facebook), accusing the firm of failing to do due diligence on the deal.

Facebook is like most other venture-funded companies in that it has common stock, which normally employees get and which typically comes with no special terms, and preferred stock, typically for investors. The preferred stock can have any number of privileges from the right to invest in future funding rounds, to board seats, to strategic partnerships. In Facebook’s case, Microsoft paid $240 million for 1.6 percent of Facebook in late 2007, in the form of preferred stock. This implied that Facebook was worth $15 billion; as part of the deal, Microsoft got strategic partnerships in advertising and search.

Meanwhile, Facebook had another valuation for its common stock, at one quarter the value of the preferred stock, or $3.75 billion, as the New York Times reported last July. Here’s the excerpt from court documents, where ConnectU got upset.

The Term Sheet and Settlement Agreement is also unenforceable because it was procured by Facebook’s fraud. Indeed, based on a formal valuation resolution approved by Facebook’s Board of Directors but concealed from ConnectU, the stock portion of the purported agreement is worth only one-quarter of its apparent value based on Facebook’s public press releases.

Facebook, we reported last July, is also required to place a current market price on its stock to satisfy Internal Revenue Services tax regulations. This is where Facebook got its $3.75 billion-valuation number, and the common stock valuation is tied to it. By tying the common stock to the IRS valuation, Facebook was essentially recognizing the value of the company sans the privileges that investors received through owning preferred stock. Of course, even the lower number is accounting guesswork, likely based on things like revenue and current market prices for social networks. Because Facebook is a private company rather than publicly traded, there is no open market to determine what the average stock investor considers the company to be worth. At this point, we don’t know important information such as whether Microsoft or other investors now consider their preferred Facebook stock to be worth less than what they got it for.

And the larger issue that we all get excited about — what Facebook is truly worth — is still mostly a matter of opinion. The company is quiet about its revenue, which was estimated at between $250 million and $300 million last year. Some people think the company’s growth trajectory (it has recently shot past more than 150 million monthly active users) and its experimental advertising efforts could one day make it worth billions. Others are more skeptical. Because Facebook is not a publicly traded company, its “official” IRS valuation will continue to be whatever the company’s auditors come up with, and its preferred stock valuation will continue to be whatever investors are willing to pay for it.