What Goldman Sachs’ Reported $450 Million Investment in Facebook May Mean

Facebook has raised $500 million at a $50 billion valuation from Goldman Sachs Group Inc. and Digital Sky Technologies, The New York Times reported last night. Facebook declined to comment, while DST did not immediately respond to inquiries.

The New York-based investment bank took a $450 million stake in the company while DST, which invested in Facebook at a $10 billion valuation in May 2009, invested an additional $50 million.

Goldman may raise as much as $1.5 billion for the company and create a special fund that lets high-net worth individuals invest in Facebook. (We reported on the phenomenon of these special-purpose vehicles, which allow companies to skirt SEC regulations about financial disclosures back in October.)

Goldman also has the right to sell part of its stake, up to $75 million, to Digital Sky Technologies. Facebook will use the funding for cashing out earlier employees, hiring talent, making acquisitions and developing new products.

A couple thoughts on the deal:

Goldman gets the inside track on underwriting Facebook’s IPO: The most obvious implication is that New York-based investment bank is leading the race to manage an anticipated IPO in 2012, which could bring in $50 to $150 million in fees to the New York-based investment bank.

The new non-IPO: For comparison’s sake, Amazon.com raised $8.3 million and Google raised just over $25 million before their respective initial public offerings. Facebook will now have raised more than $1 billion in equity investments prior to an IPO.

Avoiding an IPO may be as much about talent as anything else: Moreso than in other industries, consumer Internet companies absolutely depend upon talent. Low distribution and user switching costs mean that capital and infrastructure matter less than for other brick-and-mortar industries.

The intellectual property system in the U.S. also moves too slowly to be meaningful, so startups have to iterate or die. It’s a pattern that repeats over and over; last year’s Yahoo Answers or Flickr gives way to this year’s Quora and Instagram, which may give way to something else next year. This is why having and retaining the very best engineers, product managers and designers matters.

But as a company grows larger and as its valuation rises, its risk-reward ratio changes. At best, a rising tide means all employees benefit. However, a high valuation also creates a dual-class society where early employees are worth substantially more than newer ones. Over time, diminishing upside makes a company less attractive to the best technical talent, contributing to the cultural and bureaucratic sclerosis Google is seeing.

An IPO would be not only a distraction to Facebook; it would mean the company would lose control over its market capitalization, and the value of the rewards it could offer employees. After going public in 2004, Google’s valuation went up by about fourfold in a year as investors aggressively priced in expectations of future earnings. Currently, Google’s market capitalization is not even double what it was five years ago — a return that pales in comparison to the multiples numerous other consumer Internet startups have generated in the same time period. Hence, a technology company’s success also contains the seeds of its own destruction.

Facebook must balance between rewarding and incentivizing long-time employees to stay while making sure payoffs are attractive enough for newer employees. So far, the company has tried a combination of talent acquisitions with deals for existing employees to sell shares to specially sanctioned investors like DST. Now if you look at Sharespost bids this morning, there are multiple buy posts from investors clamoring for Facebook shares at an implied market capitalization of between $90 to $99 billion.

Taking an investment from Goldman allows Facebook to ratchet up its valuation in a controlled fashion, letting it dole out rewards to old-timers while keeping the upside attractive to newcomers.

Goldman’s “special purpose vehicle” should increase SEC scrutiny of secondary markets: We reported on special funds that let investors band together to buy shares in privately-held companies earlier this fall. Because these funds are counted as a single investor on the cap table instead of several, they help Facebook bypass the sensitive SEC 499-shareholder limit. When a company has 500 or more investors, it needs to start making financial disclosures similarly to if it were a publicly-held entity. The Securities and Exchange Commission began investigating these funds last month in a move that could pressure Facebook to go public, according to The New York Times.

Facebook may use some of the funds to buy a campus: With about 2,000 employees, it’s about time that Facebook start considering a permanent home. Eight years after it was founded, Google spent $319 million for what would become the Googleplex. It wouldn’t be surprising if Facebook did something similar. The company is somewhat uncomfortably split between two buildings on California Avenue in Palo Alto. TechCrunch reported, and we’ve also heard from sources, that Facebook is looking at property in Menlo Park.

DST may have helped snag the Facebook deal for Goldman Sachs: Two of the four DST partners hail from Goldman Sachs Group Inc. It wouldn’t be surprising if they helped arrange the deal.