Tech start-ups are proliferating around the world. They introduce technology to every aspect of our lives, from the way we communicate, to the way we care about our health, to the way we store our data. As a result, almost one third of the recent NYSE and NASDAQ IPO filings involved a tech-related corporation. However, when it comes to evaluating their potential, there is plenty of extravagancy involved, and some may say, accidentally turns young start-up founders into millionaires.
Although many start-up companies are not generating any revenue, investors still value their assets in the billions of dollars. What seems to be treasured is the access to a large group of loyal users. This is especially true in the social media industry, where a day-to-day contact with the user is key to success. Last year, Snapchat, a rapidly growing photo-messaging app, turned down a $3 billion acquisition offer from Facebook. Was Snapchat worth $3 billion? The service does not generate any revenue, but it is very popular among young people who use it to send ephemeral photos and messages to friends. Evan Spiegel, the 23 year old CEO of this Los Angeles based start-up, rejected Facebook’s offer as other investors were interested in the acquisition. He likely sensed that Snapchat, thanks to its fast developing user network, may be worth more than $3 billion in the upcoming years or even months.
Similarly, Facebook recently closed a $19 billion deal with WhatsApp, another start-up messaging service that is taking its first steps towards profitability. Is WhatsApp worth $19 billion, considering that the company generated only $20 million in revenue last year? Facebook seems to have paid for the group of over 450 million monthly active users that WhatsApp managed to attract. Zuckerberg believes that WhatsApp will soon connect 1 billion people, a business opportunity he couldn’t afford to miss.
It might be difficult to justify the acquisition figures using traditional evaluation tools, like operating margins, revenues or degree of risk involved. In the case of social media companies, the dominant driver seems to be the number of active monthly users and the possibility of a speedy increase in users. As Professor Damodaran notices, in order to pay dividends or buy back its stock, a company needs cash flows not users. Yet he says that the pricing game is not about what makes sense in the excel spreadsheet, but what traders care about. With a price hype created around Twitter’s IPO, investors placed much attention to metrics such as a vast user network and growth possibilities. As soon as Twitter reported that user growth slightly slowed down, its shares immediately plummeted.
Putting valuation fundamentals aside, there is one more pattern that is easily noticeable in the recent tech acquisitions. Instagram, Tumblr, Viber and WhatsApp were all sold to strategic investors, who unlike financial buyers, are looking for synergies between the two companies. Strategic buyers have a long-term development plan and seek to integrate the Target’s products or services with their existing ones, thus creating long-term shareholder value. When the pairing is successful, it is difficult to challenge the deal price with an argument that the price was inflated. In addition, the Target’s shareholders are satisfied that the company they invested in was ultimately sold for billions of dollars, leaving them with a nice sum.
Some commentators call this trend a ‘tech-bubble’ saying that large acquisitions are driving people to invest in the social media companies. One of the main characteristics of the ‘bubble’ is that investors are blindly speculating and, as a result, end up purchasing stock at prices they normally would not consider. The rationale behind this investment decision is different. Investors buy stock of social media companies with hopes that strategic buyers will want to monetize the large pool of users, acquire the company, and reap generous profits that exceed everyone’s expectations.