Social media: where do these billion dollar valuations come from? – Telegraph Blogs

Sunday 16 March 2014 | Blog Feed | All feeds

Alexis Dormandy


Social media: where do these billion dollar valuations come from?

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These days it seems that if you’re not valued at a billion dollars, then you’re not really trying. We’ve had Zynga, LinkedIn, Groupon. Skype went from a value of $2.75bn to $8.5bn in only two years (which implied a valuation of $1000 per paying customer – that’s an awful lot of Skype calls). Yesterday it was reported that Twitter is raising a new round of funding valuing it at $7bn, double its $3.7bn valuation of only seven months ago.

So is it gambling, or is it investing? Sometimes, it’s easy to forget the difference. As an investor, you spend money now, to get a share of the profits in the future. The higher the risk, the higher the return I should get. If I’m just hoping that I can find someone in the future to pay more than me, then I’m gambling.

It is estimated that Twitter’s revenues this year will be around $150m. That implies a valuation of over 45 times revenue. Given the risk, there had better be a lot of growth for a long time, with some very serious profit coming down the line. That’s quite some bet to take.

It may not be as sexy as billion dollar valuations, but you can only ignore the basics for so long. In the end, I need to be able to produce something more cheaply than I sell it. I recommend an excellent blog written by the VC investor Bill Gurley that should be required reading for anyone interested in investing and especially anyone interested in raising money from VC’s. It talks about competitive advantage (described by Michael Porter almost 30 years ago), predictability of revenues, barriers to entry, sustainable margins, marginal profitability, costs of growth – these things are dull, but they matter.

And if we apply those tests to new social media businesses, where do we get? Twitter hasn’t really decided on its revenue model, so predicting its revenues is quite a stretch. None of the businesses mentioned in this blog even existed ten years ago, which doesn’t say much for barriers to entry. As for margins, Skype and Groupon didn’t even make a profit last year.

A significant justification for the huge valuations we are seeing at the moment is that the leaders will be the objects of the social change, not the subjects. That may be the case for Facebook, but LinkedIn?

But there’s one last reason for the values we are seeing, and it actually has nothing to do with the companies being discussed. It comes back to the simplest rule of the lot: supply and demand. The issue is there just aren’t enough credible investments out there to make, and a lot of demand has built up over the last few years. Almost $60bn of venture capital has been raised since 2007. A decade ago, even the large VC funds raised funds of $100m. Now the largest raise funds of over $1bn. Despite the financial crisis, the first quarter of this year saw the largest amount of capital raised by venture capitalists since 2001. That money has to go somewhere.

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