08/24/2012 01:20 pm ET Updated Oct 24, 2012

When Investors Fall Flat On Their Face... Book

On the morning that Facebook went public, I was in the fourth floor conference room at Manatt, Phelps & Phillips, attending a 7 a.m. breakfast presentation by the California Capital Summit. Despite compelling speakers, there were repeated interruptions throughout the meeting as people kept asking: "Has it opened yet? What's the price?" When the Blackberrys started buzzing with news that Facebook opened at $38/share, I blurted out: "It will be below $30 within a month." The man seated next to me shook his head and confidently predicted it would be over $100 by then. He was most likely basing his estimates on the media hype that had been saturating our senses since the day Mark Zuckerberg filed the legal papers for an initial public offering (IPO).

Now, I'm not one of those folks who delight in doing the "I told you so" dance. I'm merely shocked that the current price valuation of Facebook is surprising so many people. Indeed, my husband and I had the "should we buy some shares" conversation. This was followed by the "remember what happened to MySpace" discussion before being resolved with a "let's forget about it" summation. In the days immediately prior to the IPO, little stories were scattered throughout the media -- stories that should have been pushed to the front of the discussion on every news outlet. Advertisers were reporting that they could not determine actual return on investment (ROI) from the ads they ran on Facebook. Given the fact that advertising is one of the primary sources of revenue in the Facebook business model, this was extemely important information that should have caught the eye of every investigative reporter. But once Mark Zuckerberg rang the opening bell, these stories disappeared and the buying frenzy began. Ninety days later, little stories are scattered througout the media suggesting inquiries into the methods used to determine the pre-IPO valuation of Facebook. But the real surprise is that nobody is outraged over the big cash-outs that investors and former founders are taking.

Peter Thiel was one of the first venture capital (VC) investors to hand cash to Mark Zuckerberg and his ragtag bunch. In the past 90 days, Thiel's half-a-million-dollar investment has turned into approximately $1 billion. The ripple effect throughout the investment community goes in two directions. On the one hand, VCs look for a 10:1 rate of return -- which transforms Thiel's 2000:1 rate into a record high number to fantasize about beating. Conversely, given the catastrophic crash and burn of the IPO pricing, Facebook has just made it 2000:1 times harder for the next tech startup to find their Peter Thiel.

When VCs listen to a startup team's pitch, the most crucial question they have is: What is the exit plan? The quality of the product and the nature of the business take a back seat to how the members of the team intend to deliver the investor's 10:1 rate of return. IPOs are the big brass ring because they typically generate enormous media buzz and windfall profits for the investors. Yet, mergers and acquisitions by larger companies tend to be a far more reliable way of cashing out. Exhibit A: Instagram was acquired by Facebook for $1 billion prior to the IPO because Zuckerberg apparently freaked out, realizing he needed more assets to improve the attention span of his users. It is questionable whether the Photoshop knockoff would have been independently valued that high under ordinary circumstances.

Imbedded in this cautionary tale is a wakeup call for all startups: Enjoy but ignore the media hype and focus on building a company that has devoted customers who provide a reliable revenue stream, and that is worth acquiring for a reasonable rate of return. The biggest wakeup call may be for Zuckerberg himself -- when he realizes how hard it will be to establish credibility for his next venture.