Web 2.0 Valuations: Not a hard and fast science

In all of the business school courses in entrepreneurship, venture capital/private equity, and finance, one of the overarching take aways is that valuating a company is not an easy task. The four major types of valuation methods we learned were the VC-method, free cash flow model, industry multiples of revenue, and using comparisons with other companies in your space to ballpark your company’s net worth. In class, the great thing about what we learned was that we used companies with predictable revenue growth/expectations, in industries that have been in existence since the beginning of time.

For example, a lampshade manufacturer is fairly easy to evaluate from an income statement and a cash flow statement. For anyone evaluating the company, you can uncover opportunities to create more value, and if inventory turns aren’t commensurate with the industry standard, you may be able to uncover additional value. For anyone looking to raise venture capital, the expectation is that the founding team maintains 60% of the company after the Series A, 45% after the Series B, and less than 30% after the Series C. In the new Web 2.0 world, I wonder if this benchmark is still accurate.

In this Web 2.0 world, the business school classroom strategy flies out the window, just as it did in Web 1.0. P/E ratios are outrageous, valuations based on multiple of revenues are unbelievable, and it’s virtually impossible to reasonably valuate a start-up, let alone a company with any bit of revenue. We have heard many months ago about Facebook being worth $15 billion, on less than $200 million in revenue, to Slide.com, the widget maker worth half a billion dollars, on revenue less than a couple million. Today, we learned that LinkedIN may command a $1 billion valuation. All early adopter Web 2.0 techies know this but the fact remains, my mother does not know what a widget is, and most students in my business school class have no idea what is a widget. In one of my favorite shows, Entourage, one of the main characters, Ari Gould says “What the [bleep] is a widget?” when his assistant told him that his widget had the accurate temperature. That response is similar to what I get when I ask most of my friends or family about widgets.

Henry Blodget over at the Alley Insider has attempted to valuate the top Web 2.0 properties, based on many different factors, with revenue/net income not being the primary driver. Interesting. With all the companies listed, I dare anyone to say that any of them makes over $200 million in revenue, but the list starts at valuations of $50 million all the way up to $9 billion.

If I brought that list to my business school professors, they would have a cow and cry irrational exuberance, deja-vu, dot-bomb, and a whole list of other permutations of late 90s buzzwords. Although I am highly biased, the Internet is here to stay, and it’s not about how much money you’re making today, it’s about the opportunities and value you’re creating to impact tomorrow. Today, my mom doesn’t know what a widget is, but tomorrow, she’ll realize how impactful it will be in advertising and distributing content. Even my mom joined Facebook today and “friended me”, something I would have never imagined in my wildest dreams just 18 months ago. The Internet is moving fast, and there are still so many untapped opportunities.

Henry Blodget did set himself up to be a topic of major conversation, but I commend him for getting the conversations started. With a weakening economy that still has yet to hit the bottom of where it’s going to go, it’s encouraging to know that social networking spending will continue to increase, to help fund the next generation of disruptive companies. I’d probably get roasted for saying this, and I am highly biased, but revenue should not be the primary driver of Internet valuation today, it’s the potential value that has been created to impact our lives tomorrow. Silicon Valley has understood this, and keeps to fund these projects out West, let’s just hope that in places like Chicago, our VCs can see the potential value that’s being created and take calculated chances to affect change in our tech landscape.

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7 responses to “Web 2.0 Valuations: Not a hard and fast science

  1. Marcus Ogawa

    I liked the article, and especially enjoyed the video. I think its a bubble, but like many other bubbles, its the ebb and flow of economic growth.

    The Web 2.0 bubble is waxing, it too will wane, but in the mean time, placing your chips on the right numbers may be lucrative.

  2. Marcus, thanks for stopping by. I do agree with you. Haphazardly placing bets is never the right strategy, but I do feel that there are still a great deal of good opportunities for entrepreneurs to attack, and hopefully the current economic climate doesn’t inhibit those with the great ideas from taking the plunge into entrepreneurship.

  3. Valuation of Web 2.0 companies may be focusing on asset acquisition by larger firms.

    These acquirors may have big plans for revenue growth – something that the current business ownership may not be able to achieve.

    This is known as the investment standard of business value. Note that such valuations can easily exceed the fair market value of such businesses.

    All valuations are forward-looking. As such, the results depend on the assumptions made – and hopes held by the acquirors!

  4. Marcus Ogawa

    I agree with Harry. Its kind of like the Kentucky Derby in that sense. One company publicly wins with a huge valuation during acquisition, one publicly loses with a loud bang, and more then half of the other contenders are carried away in the background either injured and limping or barely able to continue racing.

  5. I definitely agree. Remember how much of a steal Myspace was/is? When it was sold for $580 million, everyone was crying bubble this, bubble that. FOX has the horsepower to make Myspace a billion dollar a year entity. It may not be powering the FOX empire, but it was a great ROI acquisition.

  6. I also found your article interesting. I’m not convined these social networking type sites are here to stay though. So your Mom got a Facebook account. Ok, but let us know if she’s still using it a month or year down the road. It’s not clear if these types of sites are just a temporary fad, or if people ultimately find them hard to live without.

    Some services/products will fit in the latter category. The obvious example from the first bubble is Google, which isn’t going anywhere. It will always be hard to know which companies/market strategies will pay off in the long run.

    I share your hopes that Chicago VC’s will start providing seed money for more tech startups in the local area. It’s kinda silly how the valley has remained the hub that it is for so long. That, and as a software developer who wants to end up in Chicago, I guess I have a vested interest. 🙂

  7. Thanks Will for stopping by. The thing people have forgotten is that Social Networks have existed since the beginning of time informally and especially since the beginning of the Internet. Imagine if GeoCities was able to evolve and take advantage of new trends, or even AOL at its peak. What Facebook and LinkedIN has is the platform approach the enables a petri dish of innovation to occur within their site, increasing those switching costs. Everyone, including myself predicted MySpace would have been finished by now, but with annual revenues approaching a billion dollars, it’s hard to argue that they wont be here for awhile.

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