Understanding Tech Valuations
Probably one of the most loved topics amongst those discussing the tech world is “How in the world is Company X worth $10b! They don’t even have revenue!” It’s a common refrain to those both inside and outside of the industry, and usually falls back on one of a number of common arguments. I present a few guides with examples as guides to understanding how Company X can possibly be worth that much.
The first, and most important guide to understand, is that a venture capital (VC) valuation is not the same as a public market valuation. So if you see an article/tweet/opinion based around the argument of “how can Company X be worth more than Coca-Cola! They don’t even make a real product,” act like an NFL coach and throw that red flag. It’s an old fashioned case of apples to oranges. A venture capital valuation is essentially a bet on a company’s future prospects, and is a statement of what a company could one day be worth. It does not signal a company’s present total value like a publicly traded stock does. There’s a reason for the volume & rapidity of stock trading: a massive market is acting on (hopefully) publicly available information. Often VC investors are brought into the day-to-day operations of a company and have expertise in guiding young, rapid-growth businesses. Typically IPOs are reserved for mature companies that need to raise large amounts of capital for various reasons. I’m obviously painting with very broad brush strokes here, but the difference is hopefully clear.
It’s also important to remember that usually there are specific stipulations attached to VC money. Although an investor may be valuing the company at $10b, they’re not giving the company nearly that much in actually operating cash. The VC also will likely be some of the first to get their money back in case of any kind of exit.
The next guide is that there are very specific kinds of companies that are perfect for VC. The key term here is MAU: monthly active user. Most of these companies have massive aspirations, and hope to dominate markets that normal businesses couldn’t hope to capture. Any business that is ad-driven, as most of these companies are, require massive user bases to sell aforementioned ads against. For example, Facebook paid $16b for WhatsApp, which seems absurd until you consider that WhatsApp has 600m MAU and growing (and that the deal was mostly FB stock). Snapchat is another excellent example, with recent funding rounds resulting in a $10b valuation. Snapchat captures the attention of a few very valuable demographics (13–18, 18–24), has massive MAU (100m and growing), and just based on the nature of the product demands screen attention.
MAU becomes so important as we reach the stage where there’s seemingly always already an “app for that”. This means that the key metric is capturing a user’s attention. If you think of apps as a new form of media, you can draw similarities. For example, TV networks drive little revenue without viewership. An ad-supported business like Facebook (1.32b MAU) only became a profit engine ($1.5b profit FY13) after it could sell ads against its massive network of users. The type of advertising is fundamentally different (Facebook is much more targeted), but the important point is that MAU shows roughly the amount of attention an app is receiving. As the competition for your attention grows fiercer, minutes spent in an app translate directly to its worth. Facebook was widely mocked for paying $1b for Instagram, however that deal looks extremely favorable now as Instagram continues to explode (200 MAU and growing) and roll out well received ads.
The last guide to remember is that most start-ups fail. The oft-quoted statistic is only 1 of 10 new businesses makes it. VC is essentially the high rollers table for these new businesses, making huge bets and waiting for the one that pays off. There are plenty of businesses that either can’t or won’t get VC and do just fine. The companies getting the mainstream press are the ones that have made it, and often their founders have failed multiple times before launching their success. These companies are placing huge bets and attempting to own new markets, and that results in a lot of failure. The CEO of Uber had started 3 companies before finding the success that Uber has. Many companies end up creating something different than what they set out to. Instagram started life as a company called Burbn that did way more than just photos. The founders eventually decided to focus and do one thing well (this is worth a read). Sometimes, a few companies hold on and enter a very competitive battle for the same space (see: Uber v Lyft). For every company you read about executing on an idea, they were far from the only ones attempting it.
